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The Missing Preferred Return
Victor Fleischer ∗
I. INTRODUCTION .......................................................................................................... 78
II. THE PUZZLE ............................................................................................................... 80
A. Venture Capital Funds vs. Buyout Funds ............................................................. 82
1. The Carry in Leveraged Buyout Funds............................................................ 83
2. The Carry in Venture Capital Funds: The Missing Preferred Return ............. 86
B. How It Matters...................................................................................................... 86
1. Nominally Profitable Funds............................................................................. 87
2. Clawbacks in Profitable Funds........................................................................ 88
C. How Often It Matters: Empirical Evidence .......................................................... 89
III. CONVENTIONAL WISDOM .......................................................................................... 90
A. Bargaining Power................................................................................................. 90
B. Historical Explanations and Contract Stickiness ................................................. 91
C. Lack of Cash Flow................................................................................................ 92
D. Horizontal Equity with Public Company Executives............................................ 92
E. Distorting Incentives............................................................................................. 94
IV. THE EFFICIENCY (AND INEFFICIENCY) OF THE PREFERRED RETURN .......................... 95
A. Aligning Incentives ............................................................................................... 96
B. The Option Analogy.............................................................................................. 97
C. The Efficiency and Inefficiency of the Preferred Return .................................... 100
1. Assumptions ................................................................................................... 100
2. Deal Flow Incentives ..................................................................................... 101
3. Deal Harvesting Incentives............................................................................ 106
4. Summary ........................................................................................................ 108
V. A TAX EXPLANATION FOR THE MISSING PREFERRED RETURN ................................ 108
A. The Tax Treatment of Carry ............................................................................... 109
1. Timing............................................................................................................ 109
2. Character....................................................................................................... 111
B. The Impact of Tax on Carried Interest Design ................................................... 113
C. Turning the Puzzle Around................................................................................. 114
VI. CONCLUSION ........................................................................................................... 116
∗ Acting Professor, UCLA School of Law. I am indebted to Iman Anabtawi, Reuven Avi-Yonah, Steve Bank,
Robert Bartlett, Mark Greenberg, David Hasen, Jim Hines, Doug Kahn, Jeffrey Kahn, Bill Klein, Kate Litvak,
Karl Lutz, Kathy Smalley, Kirk Stark, Kathy Zeiler, Eric Zolt, and the participants of the UCLA School of Law
Faculty Colloquium, the University of Michigan Tax Policy Workshop, and the UC-Hastings Tax Policy
Seminar for their useful comments and suggestions. I am also indebted to the many venture capitalists,
investors, and practicing lawyers who spoke to me about their funds. I thank Kevin Gerson and Steven Hurdle
for valuable research assistance.
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I. INTRODUCTION
Managers of buyout funds usually offer investors an 8% preferred return on their
investment before they take a share of any additional profits. Venture capitalists (VCs),
on the other hand, offer no preferred return. Instead, VCs take their cut from the first
dollar of nominal profits. They offer investors no feature to account for investors’ cost of
capital, nor do they index their compensation to an industry benchmark. This disparity
between venture capital funds and other private equity funds is especially striking
because the contracts that determine fund organization and compensation are otherwise
very similar. This Article examines the mystery of this missing preferred return.
The missing preferred return is puzzling because it suggests that VCs may receive
“pay without performance.” 1 VCs receive incentive compensation even if their funds do
poorly when compared to other venture funds, and even when compared to less risky
investments that investors could have made. This gap between pay and performance
might even suggest that agency costs in venture capital are a more stubborn problem than
previously thought. In the public equities market, regulators strive to protect small
investors. Many laws and regulations, such as the one million dollar limit on the
deductibility of executive pay that is not linked to performance, 2 are designed to protect
investors who may not be able to effectively constrain management from extracting
rents. 3 In private equity, however, the regulatory landscape reflects the conventional
wisdom that sophisticated investors can look out for themselves. 4 The missing preferred
return poses a challenge to this view. Are fund managers camouflaging the true value of
their compensation? If not, then why would sophisticated investors pay fund managers
for mediocre work? Unlike the children of Lake Wobegon, not every venture fund is
above average. 5
Take the University of California Retirement System (UCRS), a prominent
institutional investor. More than one in ten venture funds in which the UCRS invested
has missed the common hurdle rate of 8%, and nearly one in five would have received
less compensation if the hurdle rate mechanism were used. 6 Using a preferred return
would seem to make a difference. By leaving out a preferred return term, VC fund
agreements reward mediocrity. This arrangement hardly seems efficient, let alone fair to
1. For a discussion of the problem of ineffective executive compensation design in the public company
context, see LUCIAN BEBCHUK & JESSE FRIED, PAY WITHOUT PERFORMANCE: THE UNFULFILLED PROMISE OF
EXECUTIVE COMPENSATION (2004).
2. See I.R.C. § 162(m) (2004).
3. See BEBCHUK & FRIED, supra note 1; Michael C. Jensen & Kevin J. Murphy, Remuneration: Where
We’ve Been, How We Got to Here, What are the Problems, and How to Fix Them (European Corporate
Governance Inst., Fin. Working Paper No. 44/2004, 2004), available at http://ssrn.com/abstract=561305.
4. See generally THOMAS LEE HAZEN, THE LAW OF SECURITIES REGULATION § 4.20(2) (4th ed. 2002)
(discussing definition of accredited investor).
5. See Victor Fleischer, The Rational Exuberance of Structuring Venture Capital Start-Ups, 57 TAX L.
REV. 137, 142 n.20 (discussing Lake Wobegon effect); BEBCHUK & FRIED, supra note 1, at 71-72 (discussing
ratcheting effect and noting that the vast majority of firms that use peer groups to set compensation set it at or
above the fiftieth percentile of the peer group).
6. THE REPORTS OF THE UNIVERSITY OF CALIFORNIA: ALTERNATIVE INVESTMENTS AS OF SEPTEMBER
30,
2004
[hereinafter
U.
CAL.
DATA],
available
at
http://www.ucop.edu/treasurer/invret/PE%20irr%2093004.pdf.
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retirees worried about their pension plan assets. Are VCs using compensation design to
sneakily extract rents from their investors, as CEOs are said to do?
This agency costs story starts to feel a little thin, however, when one considers the
presence of the preferred return in buyout funds. Investors routinely demand a preferred
return in buyout funds. These very same investors then accept its absence in venture
capital. With billions of dollars in fees at stake, the missing preferred return cannot be the
product of greedy managers sneaking one past sleepy investors. No one is being
hoodwinked here. Something else must be going on.
The secretive pay practices of the private equity world are worth investigating.
Private equity fund managers, recently dubbed “Capitalism’s New Kings” by The
Economist magazine, draw hefty management fees from investors and cash in on even
greater amounts by taking a share of the profits of their funds. 7 This share of the profits is
known as the “carry” or “carried interest.” In contrast to the considerable research on
CEO pay, private equity compensation practices are largely unexplored in the legal
literature. Stock options are praised or scorned, but few know enough about the carried
interest to even have an opinion. This Article uses the mystery of the missing preferred
return to take the first hard look at the compensation of private equity fund managers.
I argue in this Article that the peculiar workings of the tax law, combined with
institutional differences between venture capital and buyout funds, best explain the
missing preferred return. Many VC funds leave out a preferred return because investors
can rely on the reputation of elite VCs, along with contractual restraints, to ensure that
VCs find and invest in high-quality portfolio companies. For VC funds that may be
inclined to use a preferred return, the tax law changes the cost-benefit analysis and
discourages the use of the preferred return. Institutional differences make the preferred
return more valuable as a device for aligning incentives in buyout funds, and thus it is
employed more widely in buyout funds, notwithstanding the tax cost. The preferred
return would be used more widely in venture capital if the tax rules were changed. If I am
right about the influence of tax law, the implications are somewhat troubling. The gap
between the economics of a partnership equity interest and its treatment for tax purposes
distorts incentives by encouraging fund managers to receive more compensation in the
form of risky equity rather than cash salary, which in turn may distort the operation of the
venture capital markets. The main goal of this Article, however, is descriptive rather than
normative.
The Article proceeds as follows. In Part II, I explain the basic mechanics of private
equity compensation. I then frame the puzzle by looking at recent returns in venture
capital and considering the importance of the preferred return. In Part III, I report the
explanations offered by venture capitalists, investors, and lawyers who draft these
agreements. In Part IV, I consider the effect the preferred return may have on the
incentives of VCs. The efficiency of a given compensation scheme, I argue, may depend
on the reputation of the VC. I conclude, however, that the missing preferred return cannot
be explained by incentives and reputation alone. Part V argues that the final piece of the
puzzle is the tax treatment of a profits interest in a partnership. I argue that the tax law
encourages venture capital funds to adopt a compensation design that misaligns
incentives but still maximizes after-tax income for all parties. Part V also returns to the
7. See Kings of Capitalism: A Survey of Private Equity, ECONOMIST, Nov. 27, 2004 (special section).
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original question—the disparity between venture funds and buyout funds. I argue that the
differences in the kinds of companies buyout funds invest in make the preferred return
necessary, notwithstanding the tax cost. Part VI concludes.
II. THE PUZZLE
I begin with a prediction: the 21st century will be the golden age of private equity.
The 20th century marked the rise of the modern public corporation and with it, the
stubborn problem of the separation of ownership and control. 8 In the 1980s, the
leveraged buyout model of firm organization led some scholars to predict the eclipse of
the public corporation. 9 Public firms responded by improving efficiency; among other
things, they now routinely link pay to performance. 10 But pay for performance can tempt
executives to mislead public investors and artificially inflate short-term stock prices.
More firms are again opting to go private. 11 Legal academics, meanwhile, myopically
focus on the problem of agency costs in public companies. When academics do refer to
private equity, most praise the powerful financial incentives provided to managers. 12 But
surely there is more to it.
Private equity fund managers are playing with other people’s money, just like CEOs.
And, as with CEOs, there is some evidence that not all fund managers act like saints all
of the time. 13 Understanding the carried interest may be the key to unlocking the problem
of agency costs in private equity. Study of VC compensation began in earnest with Bill
Sahlman’s 1990 article in the Journal of Financial Economics, The Structure and
Governance of Venture-Capital Organizations, where he identified the importance of the
carried interest and noted that the option-like characteristic of the carry could distort
incentives. 14 Financial economists Paul Gompers and Josh Lerner, in their highly
8. See generally ADOLPH BERLE & GARDINER MEANS, THE MODERN CORPORATION AND PRIVATE
PROPERTY (1932) (discussing the ownership and control of corporations early in the 20th century).
9. See Michael C. Jensen, The Eclipse of the Public Corporation, HARV. BUS. REV., Sept.-Oct. 1989, at
61. The cultural importance of the rise of the leveraged buyout model was captured most memorably in
BARBARIANS AT THE GATE (HBO Home Video 1993) (illustrating the takeover of RJR Nabisco by its CEO),
see also BRYAN BURROUGH & JOHN HELYAR, BARBARIANS AT THE GATE: THE FALL OF RJR NABISCO (1990)
(describing the leveraged buyout of RJR Nabisco Corporation).
10. The link between pay and performance may be largely cosmetic, however. See BEBCHUK & FRIED,
supra note 1, at 67-68 (discussing the concept of camouflage).
11. See Ellen Engel et al., The Sarbanes-Oxley Act and Firms’ Going-Private Decisions (May 6, 2004)
(unpublished manuscript), available at http://ssrn.com/abstract=546626 (finding modest increase in goingprivate decisions as a result of Sarbanes-Oxley).
12. See Ronald J. Gilson, Engineering a Venture Capital Market: Lessons from the American Experience,
55 STAN. L. REV. 1067, 1078 (2003) (discussing the extent to which U.S. venture capital contracting models
provide guidance in creating venture capital markets in other countries).
13. I am indebted to Vic Goldberg for this nifty phrase. On evidence of agency costs in venture capital,
Marcus Cole and Joe Bankman have written that agency costs led VCs to make bad investments at the end of
the Internet bubble, when they should have been allowing investors to hold on to their money. See Joseph
Bankman & Marcus Cole, The Venture Capital Investment Bust: Did Agency Costs Play a Role? Was it
Something Lawyers Helped Structure?, 77 CHI.-KENT L. REV. 211 (2001). Paul Gompers and Josh Lerner
identify the problem of “grandstanding,” where VCs take portfolio companies public prematurely to improve
future fundraising efforts. See PAUL A. GOMPERS & JOSH LERNER, THE VENTURE CAPITAL CYCLE 239 (1999).
14. See William A. Sahlman, The Structure and Governance of Venture-Capital Organizations, 27 J. FIN.
ECON. 473, 494-99 (1990).
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influential book, The Venture Capital Cycle, argued that establishing reputation was an
important motivation for new VCs, and that the compensation of established funds was
more sensitive to performance than that of other funds. 15 In recent years economists have
written literally hundreds of articles about venture capital, though few articles examine
agency costs at the fund level. 16
The legal academy has a long way to go in order to catch up with financial
economists. Ron Gilson was the first legal academic to pay close attention to the agency
costs problem in venture capital. Gilson noted that the general partner’s compensation
structure is the “front line response to the potential for agency costs” resulting from
giving the general partner control over the fund’s investments. 17 But Gilson’s discussion
of the carried interest stopped short of a detailed examination of carried interest design. 18
More recently, Kate Litvak has undertaken an empirical study of venture capital fund
agreements. 19 Among other things, Litvak argues that the practice of staging capital calls
creates an option to abandon that helps mitigate agency costs. 20 Other developments in
private equity fund contracting that may address agency costs, such as “no fault divorce”
clauses that allow limited partners to fire the general partner, have yet to receive much
attention by the academy. 21
Private equity gives us a window, relatively free from the distortions of securities
regulation, to see what sort of private ordering the market can develop on its own to
address agency costs. While I conclude in this Article that private ordering fails to
properly align incentives, the distortion here is not caused by collective action problems,
boardroom culture, camouflaged compensation, or accounting rules. Instead, the villain is
the tax law. The peculiar tax treatment of a profits interest in a partnership encourages
parties to keep the status quo, even though some alternative designs might better align
incentives.
15. See GOMPERS & LERNER, supra note 13, at 81.
16. An SSRN search for the term “venture capital” in the title or abstract generated 500 hits; a search for
“venture capital” in only the title generated 199 hits. See Social Science Research Network,
http://www.ssrn.com (last visited Apr. 6, 2006).
17. See Gilson, supra note 12, at 1089; see also Joseph W. Bartlett & W. Eric Swan, Private Equity
Funds: What Counts and What Doesn’t?, 26 J. CORP. L. 393 (2001) (noting importance of design of carried
interest); David Rosenberg, The Two “Cycles” of Venture Capital, 28 J. CORP. L. 419 (2003) (describing how
the threat of litigation used between venture capital limited partners is largely hollow); David Rosenberg,
Venture Capital Limited Partnerships: A Study in Freedom of Contract, 2002 COLUM. BUS. L. REV. 363 (2002)
(discussing incentive created by limited partnerships organized under Delaware law).
18. Regarding the design of the carried interest, Gilson noted only that certain adjustments could be made
after the fact to prevent certain abuses by the general partner. These adjustments are known as “clawbacks.” See
Gilson, supra note 12, at 1089; JAMES M. SCHELL, PRIVATE EQUITY FUNDS: BUSINESS STRUCTURE AND
OPERATIONS § 2.04[2] (Law Journal Press 1999) (1949).
19. Kate Litvak, Governance Through Exit: Default Penalties and Walkaway Options in Venture Capital
Partnership Agreements, 40 WILLAMETTE L. REV. 771 (2004).
20. See id. But see Victor Fleischer, Fickle Investors, Reputation, and the Clientele Effect in Venture
Capital Funds, 40 WILLAMETTE L. REV. 813 (2004) (questioning whether default penalties are an effective
governance device).
21. See DAVID TOLL, PRIVATE EQUITY PARTNERSHIP TERMS AND CONDITIONS 62 (2d ed. 2001);
WILLIAM M. MERCER INC., KEY TERMS AND CONDITIONS FOR PRIVATE EQUITY INVESTING 42 (1996)
[hereinafter MERCER REPORT].
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A. Venture Capital Funds vs. Buyout Funds
Like the dog that didn’t bark, 22 the missing preferred return is remarkable only in
context. Private equity funds share basic structural qualities even though the underlying
companies they invest in vary widely. The private equity market is made up of distinct
investment partnerships called funds. Each fund uses a pre-defined investment strategy
that focuses on a particular asset class: investors may choose from buyout funds, real
estate funds, venture capital funds, Asian funds, mezzanine funds, and so forth. 23 Within
each asset class, funds may target particular industries within a sector, such as Internet
companies, software, biotechnology, or health care start-ups. 24 This Article focuses on a
difference in compensation structure in two particular types of private equity funds,
defined by asset class: venture capital funds and buyout funds. Although I focus on the
preferred return in buyout funds, what is true for buyout funds is also generally true for
real estate funds, mezzanine funds, funds of funds, and other private equity investments.
When it comes to the preferred return, venture is different.
Basic fund organization is the same for venture funds and buyout funds. Funds are
organized as limited partnerships or limited liability companies under state law. Investors
become limited partners (LPs) in the partnerships and commit capital to the fund. A
general partner (GP) manages the partnership in exchange for an annual management fee,
usually between 1.5% and 3% of the fund’s committed capital. The GP also receives a
share of any profits; this profit-sharing right is called the “carry” or “carried interest.”
The carried interest aims to align the incentives of the GP with those of the LPs. Because
the GP can earn significant compensation if the fund performs well, the fund managers
are driven to work harder and earn profits for the partnership as a whole. The GP also
contributes about 1% of the capital to the fund. This amount, which is largely an artifact
of tax history, 25 is small in comparison to the carry and generally has a negligible effect
on incentives.
22. See ARTHUR CONAN DOYLE, Silver Blaze, in ADVENTURES OF SHERLOCK HOLMES 645, 656-57 (Univ.
of Va. Library 1995) (1891).
“Is there any other point to which you wish to draw my attention?”
“To the curious incident of the dog in the night-time.”
“The dog did nothing in the night-time.”
“That was the curious incident,” remarked Sherlock Holmes.
Id.
23. The type of fund, in other words, refers to the type of investment rather than who the investors are.
24. For example, in 2002 venture investments were divided into the following sectors: communications
(including Internet) 24%, computer software 20%, biotechnology 13%, healthcare related 11%, computer
hardware and services 9%, semiconductors and electronics 7%, retailing and media 7%, business/financial 4%,
and industrial/energy 4%. See THOMSON VENTURE ECONOMICS, 2003 NATIONAL VENTURE CAPITAL
ASSOCIATION YEARBOOK 28 (2003).
25. Before the check-the-box rules, a 1% capital interest was necessary to help ensure partnership
classification for tax purposes. See SCHELL, supra note 18, § 3.02[2]; Victor E. Fleischer, If It Looks Like a
Duck: Corporate Resemblance and Check-The-Box Elective Tax Classification, 96 COLUM. L. REV. 518 (1996)
(discussing the check-the-box elective tax in the context of corporate resemblance). Some LPs are pushing for
an increase to 2% or 3%, which may reflect some of the concerns discussed in Part IV.C.3.
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Figure 1: Fund Organization
Investment Professionals
LP
LP
LP
LP
LP
GP
Capital Interests
Carried
Interest
Private Equity Fund I, L.P.
Portfolio Companies
After formation, the GP deploys the capital in the fund by investing in different
operating businesses, known as portfolio companies. After making the initial investment,
the GP becomes a formal or informal advisor to the companies. In most venture funds,
the portfolio companies are high-tech start-ups, and the GP’s ultimate goal is to take the
portfolio companies public or sell the companies’ stock or assets to another company. In
buyout funds, the fund makes sizeable investments in mature companies. The fund then
might reorganize the company, change its corporate strategy, or make aggressive changes
in management to improve its operations. Buyout funds then eventually sell each
portfolio company to a trade buyer, break it up and sell off the assets, or take the portfolio
company public again, selling shares back to public shareholders at a profit. Lately, with
IPO markets cold, buyout funds have increasingly looked to sell to other buyout funds as
an exit strategy.
Both venture capital funds and buyout funds use the carried interest to create
powerful economic incentives for the GP. The GP is itself a partnership or LLC with a
small number of professionals as members. The GP receives a management fee that
covers administrative overhead and pays the managers’ salaries. The management fee is
fixed and does not depend on the performance of the fund. The carry, on the other hand,
is based on performance. Because private equity funds are leanly staffed, a carried
interest worth millions of dollars may be split among just a handful of managers.
1. The Carry in Leveraged Buyout Funds
In buyout funds, the carried interest is subject to a preferred return requirement that
works as follows. Before the GP receives any carry, the LPs first receive a preferred
return on their investment, often 8%. The preferred return ensures that LPs receive at
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least as much as they would have made on safer market investments before the GP takes
a share of the profits. The mechanics of allocation and distribution of profit and loss in
partnership agreements are famously intricate and difficult to follow. While the general
structure of fund agreements is largely standardized, details in drafting vary, and certain
terms, like those pertaining to the timing of distributions, are often heavily negotiated. 26
Without spelunking too deep into partnership agreement drafting issues, it is worth
highlighting the basic mechanics of partnership allocation and distribution as they pertain
to the preferred return.
Capital accounts track the economic arrangements of partnerships. Allocation
provisions increase and decrease capital accounts of individual partners as the partnership
realizes gains or losses. Thus, when a fund sells an investment at a profit, each partner
receives an allocation of profit and its capital account is increased according to the terms
of the agreement. Distribution provisions then determine the order each partner receives
actual distributions of cash or securities. When there is a gap between allocation and
distributions, the difference is made up when the fund is liquidated. 27 Capital accounts
thus define the true economic arrangement amongst the partners; timing and credit risk
issues aside, a partner’s take will ultimately match the partner’s capital account. The
partnership agreement may be drafted so that the key economic terms are stated in either
the allocation or distribution provisions; for simplicity here I assume that the allocation
provisions do the heavy lifting and that the distributions then follow the allocations.
An allocation provision with a preferred return could say that as gains are realized
from partnership investments, allocations will occur as follows: first, 100% to the LPs
until such time as the LPs have received back their initial contribution of capital; second,
100% to the LPs until they have received an amount equal to an 8% return, compounded
annually on their initial investment; and thereafter, 80% to the LPs and 20% to the GP. 28
Such an arrangement is called a “true” preferred return. It is also sometimes called a
“floor,” because the GP receives no carry until reaching the 8% return.
The phrase “hurdle rate,” often used interchangeably with “preferred return” in the
industry, more accurately describes the actual mechanics of most agreements. 29 A hurdle
rate means that once the GP has returned the initial capital plus an 8% return, it has
cleared the hurdle and becomes entitled to take the full 20% carry. To achieve this goal,
the agreement includes a “catch-up” provision. A partnership agreement with a hurdle
rate thus might say that allocations take place as follows: first, 100% to the LPs until the
26. See Bartlett & Swan, supra note 17, at 406.
27. Sometimes, there is not enough cash remaining in the partnership to square off the accounts at
liquidation. In that case, a clawback provision will be used to ensure that the economics of the partnership
ultimately match up with the capital accounts. See infra text accompanying notes 29-31.
28. A brief numerical example may help. Suppose the LPs contribute $100 to the partnership, which buys
stock in a single company, Acme Inc., for $100. One year later the partnership sells its Acme stock for $158.
The first $100 is allocated to the LPs, returning their initial investment in the partnership. The LPs are then
allocated $8, representing the preferred return. Fifty dollars remains and is split 80-20, with the LPs receiving
an allocation of $40 and the GP receiving an allocation of $10. The LPs will have capital accounts totaling $148
($100 + $8 + $40) and the GP will have a capital account of $10. Note that because of the preferred return, the
GP’s final share of the profits is less than 20% ($10 divided by $58 equals 17.2%).
29. See JACK S. LEVIN, STRUCTURING VENTURE CAPITAL, PRIVATE EQUITY, AND ENTREPRENEURIAL
TRANSACTIONS ¶ 1002.1, at 10-10 (Martin D. Ginsberg & Donald E. Rocap eds., 2004) (noting that “permanent
preferential return” is used less commonly).
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LPs have received 100% of their initial capital back; second, 100% to the LPs until the
LPs have received an amount equal to 8% return, compounded annually, on their initial
investment; third, 100% to the GP until the GP has “caught up” and received 20% of the
amount in excess of the initial investment; and thereafter, 80% to the LPs and 20% to the
GP. 30 In contrast to a true preferred return, the significance of the hurdle rate vanishes
after it is cleared. After the catch-up amount, the GP receives 20% of the total nominal
profits of the fund, erasing any measure of the LPs’ cost of capital.
The compounding of the preferred return rate is what makes it an important contract
term. Private equity funds have a life, defined by contract, of 10 to 12 years. If an LP
invests $100 in a ten-year fund, an 8% preferred return (compounded annually) means
that it must receive $216 before the GP may take any carry.
Complicating matters even further is the fact that, in many partnership agreements,
the hurdle must only be cleared once. A fund may invest in as many as 10 or 15 portfolio
companies, each of which is later sold at a different time. Many fund agreements are
structured so that if the GP realizes an investment (i.e., sells a portfolio company) or
series of investments at a cumulative profit that clears the then-applicable hurdle rate, the
catch-up provision kicks in and the GP is thereafter entitled to its 20% carry, even if the
fund’s overall return falls below 8% in the long run. Thus, if a fund has one or two early
successes at a large profit, and then equal successes and failures thereafter, for an overall
return of 5%, the GP would receive 1% (20% of the 5%) as carry.
Finally, some funds allow the GP to receive carry on a deal-by-deal basis, making a
“clawback” provision necessary. A “clawback” provision determines what happens when
the GP has some early successes, which entitles it to receive carry, but then sees later
investments fail to show profits. If the overall return of the fund drops below zero, then
the GP will incur an obligation to return the amount received as carry to the fund. The
clawback ensures that the carry is ultimately determined on an aggregate level, rather
than portfolio company-by-portfolio company. 31
The mechanics of allocation, distribution, and clawback are as important as they are
difficult to draft. These provisions determine how funds divide up profits; as such, they
influence the behavior of the managers.
30. Suppose the LPs contribute $100 to the partnership, which then buys stock in a single company, Acme
Inc., for $100. One year later the partnership sells its Acme stock for $158. The first $100 is allocated to the
LPs, returning their initial investment in the partnership. The LPs are then allocated $8, representing the
preferred return. The GP is then allocated $2, representing the catch-up. Forty-eight dollars remains, and is split
80-20, with the LPs receiving an allocation of $38.40 and the GP receiving an allocation of $9.60. The LPs will
have a capital account of $146.40 ($100 + $8 + $38.40) and the GP will have a capital account of $11.60 ($2 +
$9.60). Note that because of the catch-up provision, the GP’s final share of the profits is exactly 20% ($11.60
divided by $58).
31. For example, suppose the LPs invest $100 in a fund, which invests $50 in Beta Inc. and $50 in
portfolio company, Gamma Inc. One year later the Beta stock is sold for $85. Under the terms of the partnership
agreement, the first $50 is allocated to the LPs, the next $4 (8% of $50) is allocated to the LPs, the next $1 is
allocated to the GP (the catch-up amount), and the remaining $30 is split $24-$6 between the LPs and the GP.
The GP has thus received $7 in carry from the $35 in profits from the sale of Beta stock. The LPs have received
a total of $78. Nine years later, Gamma Inc. files for bankruptcy, and the fund’s Gamma stock is deemed
worthless. The fund prepares for liquidation. Under the terms of the partnership agreement, the GP must return
the $7 of carry to the partnership since the LPs have not received back their initial $100 investment in the fund.
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2. The Carry in Venture Capital Funds: The Missing Preferred Return
Venture capital funds, in contrast to other buyout funds, do not give LPs a preferred
return or hurdle rate. All profits are divided 80-20 between the LPs and the GP. While
obviously simpler than using a preferred return mechanism, this allocation seems to fail a
basic goal of contingent compensation arrangements: rewarding superior performance.
By failing to use a preferred return, venture funds reward both superior and mediocre
performance.
A simple example illustrates the problem. Suppose the LPs invest $100 million in a
typical fund with a ten-year life. The fund shows returns of 4% per year, and at the end of
ten years the portfolio companies are sold for a total of $148 million. Despite this subpar
performance, the GP will receive nearly $10 million of carry. And yet the LPs could have
achieved a better return on their investment by investing in safer securities, such as
corporate bonds or even Treasury bonds. Given the sophistication of the institutional
investors who make these investments, the compensation design is puzzling.
The absence of a preferred return in venture funds is common but not universal. In a
recent detailed empirical study of venture capital partnership agreements, none of the 38
agreements studied contained a preferred return. 32 Most practitioners I spoke with
reported not using a preferred return. On the other hand, a 2001 industry study reported
that “[p]referred returns have become dramatically more popular among venture funds in
the past two years.” 33 That study reported that 35% of venture capital fund agreements
included a preferred return. 34 It is useful to know that some venture funds do include a
preferred return; one possibility, discussed below, is that the VC’s reputation helps
account for the disparity in contract design. 35 Similarly, the presence of the preferred
return in buyout funds is common but not universal. In one recent survey, 90% of buyout
funds used a preferred return. 36
B. How It Matters
Venture investing is risky business. At first glance, considering the presence or
absence of a preferred return seems like a trivial pursuit. After all, if a venture fund
invests in a series of Internet flame-outs, the GP would not receive any carry at all. If it
funds the next Google, returning the LPs’ initial investment ten-fold, then the GP would
clear any hurdle, making the preferred return irrelevant. 37
In fact, the absence of a preferred return can and does make a difference in the real
32. See Litvak, supra note 19. In an e-mail exchange, Professor Litvak confirmed that none of the
agreements contained preferred return provisions. E-mail from Kate Litvak, Assistant Professor of Law, The
University of Texas School of Law, to Victor Fleischer, Acting Professor, UCLA School of Law (July 26,
2004) (on file with author).
33. TOLL, supra note 21, at 53.
34. Id.
35. See infra text accompanying notes 99-100; Daniel Covitz & Nellie Liang, Recent Developments in the
Private Equity Market and the Role of Preferred Returns (Jan. 2002) (unpublished manuscript), available at
http://www.bis.org/publ/cgfs19board1.pdf.
36. See TOLL, supra note 21, at 52.
37. See Gary Rivlin, Google is One for the Books, Leaving Some With Regrets, N.Y. TIMES, Aug. 23,
2004, at C1 (discussing how Google’s VCs turned $11 million into $3 billion in five years).
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world. The compounding effect of the preferred return calculation makes it significant
over the course of a 10- or 12-year fund. Moreover, the risky nature of venture investing
is sometimes overstated. It is certainly true that many of the underlying investments in
start-ups will turn out to be worthless. The gamble at the portfolio company level is
moderated, however, by the aggregation of risk at the fund level. A venture fund might
make investments in 10 or 15 portfolio companies. While each individual portfolio
company is very risky, funds are somewhat less so.
And so it is worth a closer look at when the preferred return really matters. The
preferred return matters when one of two situations arises: the funds make some profits
but never clear the hurdle rate, or the funds are profitable and clear the hurdle but then
fall back.
1. Nominally Profitable Funds
The first and more obvious way that the preferred return makes a difference is when
a fund is profitable but never clears the hurdle rate. Suppose LPs invest $100 in a fund
and ten years later receive back $150. In the absence of a preferred return, even though
the investment has a negative net present value (in hindsight), the GP is able to take $10
of the $50 “profit” as the carried interest. If the partnership agreement included a
preferred return, the GP receives no carry.
Figure 2: Basic GP Payout Diagram
GP
Payout
54
Hurdle Rate
Straight Carry
True Preferred Return
0
No
Carry
Catch
Up
Zone
Hurdle
Zone
216
100
Full
Carry
270
Total Fund Value
Figure 2 shows the payout scheme for (1) a “straight carry” (i.e., a fund with no
preferred return—most VC funds); (2) a “hurdle rate” (i.e., a fund with a preferred return
and a 100% catch-up provision—most buyout funds); and (3) a true preferred return. The
top line represents the payout for most VC funds and shows positive returns starting at
100 and increasing with a slope of 0.2 (20%). The bottom line shows the payout for a true
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preferred return, starting at 216 and increasing with a slope of 0.2. The middle line,
which represents the payout for most buyout funds, starts at 216 (the hurdle number) but
starts with a slope of 1 (100%). This is the catch-up period, where every additional dollar
earned by the fund is allocated to the GP. Once the catch-up point is reached, additional
allocations are 80-20, bringing the payouts back in line with funds with no preferred
return.
The triangle in the middle represents the possible difference in value between a fund
with and without a hurdle rate. If the fund value falls between 100 and 270, the value of
the preferred return to the LPs can be determined by the height of the triangle at that
point. The expected value of the preferred return is more difficult to calculate, of course,
because it depends on the probability that the fund value will end up in that range and the
effect that the preferred return has on that probability.
2. Clawbacks in Profitable Funds
The second, more subtle way that the preferred return makes a difference is in the
calculation of clawbacks. Suppose a fund has some early successes but later failures. At a
minimum, the GP, which received carry on the early successes, has to give back any
carry in excess of 20% of cumulative profits.
Some partnership agreements go further, however, requiring the GP to give back any
carry in excess of the initial capital investment plus a preferred return. 38 Suppose a fund
with an initial value of $100 has some early success, reaping $110 from the sale of
portfolio companies and a total profit of $30. The GP receives $6 of carry. The remaining
portfolio companies fail, and the fund liquidates after three years. The preferred return
now amounts to $126. 39 At the time of liquidation, the GP would have to give back not
just the $4 in excess profits, but the full $6 because the fund has returned just $110; it has
not, in the aggregate, cleared the $126 hurdle. Such a clawback provision, which I call a
“creeping clawback,” reflects the economics of a true preferred return by guaranteeing a
minimum return to the LPs in any profitable situation. Without a creeping clawback, a
preferred return accomplishes this goal if the fund has failures before successes but not
vice versa. 40
38. See SCHELL, supra note 18, § 2.04, at 2-18 to -23.
39. The calculation is as follows: $100(1.08)3= $126.
40. A creeping clawback reduces an important timing benefit the GP enjoys when early successes in a
fund are followed by later failures. Under a traditional clawback, the GP must return excess carry to the fund,
but without interest. Kate Litvak has noted how this is equivalent to an interest-free loan from the LPs to the
GP. See Litvak, supra note 19, at 8. In the example above, under a traditional clawback, the GP keeps $2 and
returns $4 to the LPs for a net of 20% ($2 out of $10 of total profits). In addition, however, the GP has enjoyed
the use of the $4 in the interim, interest-free.
Litvak’s research suggests that this timing benefit is quite valuable. Under a creeping clawback, the
GP returns the full $6 of nominal carry to the LPs. While the GP still enjoys the use of the $6, the overall return
to the GP is obviously much lower than a traditional clawback. Under a traditional clawback, the GP keeps $2
plus the interest on $6; under the creeping clawback, the GP keeps just the interest on $6. One might be troubled
by the GP receiving anything in this situation; one could imagine forcing the GP to pay back interest as well,
even if that meant forcing the GP to dip into its own pocketbook beyond previously received carry.
Traditionally, funds have avoided asking the GP to ever pay money into the fund beyond a 1% capital
commitment at the time of initial investment.
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C. How Often It Matters: Empirical Evidence
What impact would including a preferred return have on real world venture capital
funds? Empirical data suggests the term is more important than conventional wisdom
suggests. For the University of California Retirement System, a prominent institutional
investor, 9 out of 46 venture funds from vintage years 1979 through 1998 showed returns
below 10%. Of these, 4 were between 8% and 10%, which would place the fund in the
“catch-up” zone. Three others were positive, but below 8%. 41 Thus, for the University of
California, in 7 out of 46 funds the presence of the preferred return term would have
affected the payment of the carried interest to the GP.
This apparent pay for underperformance is likely to worsen over the next few years.
Many venture funds in vintage years 1999, 2000, and 2001 invested heavily in Internet
companies. GPs took carry on early successes as dot-coms went public. Remaining
portfolio companies have a slim chance of matching those earlier successes; many expect
the returns for funds from vintage years 1999 to 2003 to have subpar returns. 42
A possible explanation for the lack of academic attention paid to the missing
preferred return is the difficulty of obtaining data. Venture capital funds are exempt from
the reporting requirements of the securities laws. 43 Investors instead bargain for
contractual rights to observe how their capital is being deployed and to calculate returns
based on actual cash received back from the partnership. Because this information is
confidential, it is difficult to find reliable data showing returns for large numbers of funds
over time to get a full sense of the importance of the preferred return. 44 Practitioners
report that arguments about the preferred return often devolve into simplistic arguments
about what the “industry standard” is. 45
The fact that the preferred return only comes into play in a subset of cases does little
to explain the puzzle. Given that buyout funds and other private equity funds routinely
include hurdle rates, one would expect venture funds to follow suit, all else being equal.
More importantly, perhaps, clearing the hurdle rate does not mean that the contract term
was irrelevant. The significance of the preferred return term is more than distributional; it
changes incentives. In the absence of a preferred return term, a GP may do a mediocre
job, performing below the industry average, and still receive a nominally performancebased reward. The puzzle remains, then: Why do venture funds fail to include a preferred
return?
41. See U. CAL. DATA, supra note 6. The relevant returns were: 5.5%, 7.0%, 8.4%, 9.2%, 8.4%, 4.5%,
9.3%, -10.7%, and -4.3%. Variation in the calculation of the preferred return makes it difficult to know for sure
how many funds would be affected. Still, this frequency is enough to show that the contract term is not trivial.
42. To make matters worse, as noted above, VCs who have taken carry on early successes have a strong
incentive to delay liquidation of the fund, as the benefit of holding on to carry without incurring interest has
significant financial impact. See Litvak, supra note 19, at 8. A creeping clawback would counteract this
incentive to delay by increasing the amount the GP must pay back to the fund by 8% per year.
43. See SCHELL, supra note 18, § 8.01[1].
44. More data have become available recently as journalists and investor watchdogs use state public
records statutes to request information about the investment returns of state pension funds. GPs are not pleased
about this trend, nor are LPs who are being asked to leave some of the most prestigious funds. See Ann Grimes,
Disclosure Dilemma: Their Secretive Ways at Stake, WALL ST. J., May 11, 2004, at A1.
45. See Bartlett & Swan, supra note 17, at 394.
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III. CONVENTIONAL WISDOM
The conventional wisdom about the missing preferred return is grounded in the
“home run” mentality of venture investing. 46 Most private equity funds—real estate
funds, buyout funds, mezzanine funds, etc.—invest in established companies with
positive cash flows. Venture funds, on the other hand, invest in start-ups with no
immediate possibility of positive cash flow and only an uncertain hope of making money
in the future. Venture funds like to bet on “disruptive technologies”—companies with
products that can change entire product markets. Most of these risky bets fail. The highrisk, high-reward strategy makes it silly, say some fund managers, to quibble about
preferred returns. Either the gamble pays off and everyone goes home happy, or they
shake it off and look to the next fund.
The problem with this “home run” mentality explanation is that investors seem
unlikely to fall for it. The underlying assumption—that venture funds are either
enormously successful or complete failures—simply is not true. It is true that within
venture funds many portfolio companies fail, a few succeed, and only a few become
“zombies” with middling returns. 47 However, because funds aggregate investments in as
many as 15 or 20 portfolio companies, they have less variable returns. When funds do
moderately well, hurdle rates come into play. Moreover, if the presence or absence of a
preferred return were insignificant, then one might just as well expect to find the term
included rather than excluded, given its nearly universal presence in other types of private
equity funds.
A. Bargaining Power
Many venture capitalists offered bargaining power as an explanation for the absence
of a preferred return. The demand for venture capital funds soared in the late 1990s,
putting VCs in a favorable bargaining position. But bargaining power, by itself, cannot
explain the puzzle. Bargaining power is better at explaining the amount of compensation
one receives rather than the form of the compensation. 48 Nor does bargaining power
explain why VCs would choose to exercise their power here, on such an arcane contract
term, rather than elsewhere in the contract. After all, the preferred return term only
matters in certain circumstances. An optimistic VC might bargain for a higher percentage
of the profits; a pessimist might bargain for a higher management fee. Only a deeply
ambivalent VC would bargain for the absence of a preferred return term.
Moreover, bargaining power has limited explanatory power because VCs have not
always been in the dominant position at the negotiation table. As recently as the mid1990s, many venture funds offered attractive deal terms to lure investors. At the peak of
46. See Fleischer, supra note 5, at 148; Joseph Bankman, The Structure of Silicon Valley Start-Ups, 41
UCLA L. REV. 1737 (1994) (discussing and defining the “home run” mentality in venture investing as receiving
a return that is greater than two times the investment).
47. See Ronald J. Gilson & David M. Schizer, Understanding Venture Capital Structure: A Tax
Explanation for Convertible Preferred Stock, 116 HARV. L. REV. 874 (2003) (arguing that middle ground is
relatively small and cannot explain use of preferred stock).
48. See, e.g., Stewart J. Schwab & Randall S. Thomas, An Empirical Analysis of CEO Employment
Contracts: What Do Top Executives Bargain For? (Cornell Law Sch. Research Paper No. 04-024, Vanderbilt
Law & Econ. Research Paper No. 04-12, 2004), available at http://ssrn.com/abstract =529923.
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this pro-LP period, a group of prominent institutional investors retained a consulting firm,
Mercer Investment Consulting, to recommend changes to the design of fund agreements
that LPs should press for. 49 The Mercer Report proved to be controversial within the
venture industry. The report recommended some aggressive, pro-LP changes like no fault
divorce clauses, advisory committees, and suspension-of-capital-call provisions. 50 Some
changes have been widely adopted, others have not. 51 What is remarkable is that in the
midst of this wish list, the Mercer Report offered only lukewarm support for a preferred
return in the venture context. 52 If bargaining power were the true explanation, one would
have expected the Mercer Report to unambiguously suggest that LPs press for the term.
B. Historical Explanations and Contract Stickiness
History provides a clue, namely that the institutional differences between venture
funds and buyout funds may help solve the puzzle. When venture funds were first formed
in the 1950s and 1960s, returns were calculated on an investment-by-investment basis
(i.e., portfolio company-by-portfolio company). Given the volatility of portfolio company
returns, returns rarely fell in the middle range where the preferred return would come into
play. The costs of negotiating the term, drafting it, and explaining its relevance to clients
may have even exceeded any increase in efficiency. 53
Practitioners devised the preferred return when real estate funds and leverage buyout
funds grew in popularity in the 1970s. The expected returns from real estate and buyout
investments were smaller and less volatile than venture investments. Also, these funds
began to calculate the carried interest on the aggregate level, further reducing the
volatility of returns. With middling returns more common, investors settled on a hurdle
rate as a way of calculating a performance-based return. Little has changed since the
1970s: buyout, real estate, and other funds generally have a preferred return, while
venture funds generally do not.
Nowadays venture funds also calculate profits on an aggregate basis, not deal-bydeal. History helps explain the initial divergence but does little to justify the status quo.
The stickiness of contract terms is another possible barrier between the status quo and a
more efficient contract. 54 Absent a pressing need to change, lawyers tend to copy
language from prior agreements and may not fully consider other options. 55 In this case,
49. MERCER REPORT, supra note 21.
50. Id. at 1-4.
51. See generally TOLL, supra note 21 (discussing current practices).
52. See MERCER REPORT, supra note 21, at 25. The Mercer Report’s reasoning is discussed below.
53. There are both distributional and efficiency implications for the preferred return; it only makes sense
to add a new term to a contract if the efficiency gains outweigh the drafting costs. If the drafting costs exceed
efficiency gains, thereby creating a net efficiency loss, then both parties are better off leaving the term out.
54. See Stephen J. Choi & G. Mitu Gulati, Innovation in Boilerplate Contracts: An Empirical Examination
of Sovereign Bonds, 53 EMORY L.J. 929, 940 (2004); Marcel Kahan & Michael Klausner, Antitakeover
Provisions in Bonds: Bondholder Protection or Management Entrenchment?, 40 UCLA L. REV. 931 (1993)
(discussing the interaction of interests among bondholders, shareholders, and managers as related to contractual
bondholder protection); Marcel Kahan & Michael Klausner, Standardization and Innovation in Corporate
Contracting (or “The Economics of Boilerplate”), 83 VA. L. REV. 713 (1997) (offering an empirical analysis of
how increasing returns influence standardization, customization, and innovation in corporate contracts).
55. See Claire A. Hill, Why Contracts are Written in “Legalese,” 77 CHI.-KENT L. REV. 59, 62-70 (2001).
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however, contract stickiness is an unlikely explanation. The cost of switching to a
preferred return is very low. The increase in drafting costs is minimal: the same law
firms, and often the very same lawyers, draft fund agreements for both buyout funds and
venture funds, and thus could easily drop in language that works. Moreover, these same
lawyers are already familiar with the mechanics of preferred returns, making the cost of
educating clients relatively low. Furthermore, the language at issue is not boilerplate;
terms are scrutinized and negotiated, especially in recent years. 56
Thus, while history can help explain how the disparity between venture and buyout
developed, it does little to explain the disparity’s persistence. With large amounts of
money at stake and switching costs relatively low, one would expect the lawyers and
investors who negotiate these contracts to gravitate towards more efficient contract terms.
C. Lack of Cash Flow
The Mercer Report suggested that a preferred return would be inappropriate for
venture funds because the underlying portfolio companies in venture funds—start-ups—
do not have any cash flow available to pay the preferred return. 57 Buyout funds, on the
other hand, invest in established companies that generate cash. The intuition seems to be
that a preferred return only makes sense when a steady stream of cash flow exists.
The intuition is understandable. Paying a preferred return on a risky investment is
counterintuitive. In most contexts, when an investor is entitled to a preferred return, the
return is actually paid, and not just accrued, on a quarterly or semi-annual basis from cash
flow generated by the business. A holder of preferred stock in a corporation expects to
receive regular dividends. Investors, therefore, generally associate preferential payouts
with the availability of cash flow.
Like bargaining power and history, however, cash flow fails to hold up as a robust
explanation. Because LPs lack the power to place the fund in default if the preferred
return is not paid, interim cash flow is not relevant; only the ultimate performance of the
fund matters. The goal of the preference is to benchmark the performance of the manager
by affecting the capital account, not to establish priority of distribution of available
interim cash flow. Preferences perform this role in other areas of corporate finance and
even in the venture context. For example, in the case of convertible preferred stock
investments in start-ups, the dividend preference may accrue, giving the fund a larger
stake in the company over time, and also giving the preferred stockholders priority in the
event of liquidation. 58
D. Horizontal Equity with Public Company Executives
Efficiency may not be the only driver of compensation practices. Horizontal
equity—in the sense of making as much money as one’s peers—might also help explain
56. See Jerry Borrell, Work in Progress, VENTURE CAP. J., Jan. 2004, at 26.
57. See MERCER REPORT, supra note 21, at 25. Given the disparity between venture funds and the rest of
private equity, one would have expected the Mercer Report to recommend including a preferred return. In fact,
the Mercer Report says little about the absence of the preferred return in venture funds; it notes only that “[i]t is
found less frequently in early stage venture capital funds because these investments generally do not produce
cash early in the life of the partnership.” Id.
58. See Gilson & Schizer, supra note 47.
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the makeup of a compensation package. The leading treatise on private equity funds,
James Schell’s Private Equity Funds: Business Structure and Operations, justifies the
missing preferred return by pointing to public company executives. 59 Public company
executives, Schell explains, do not have similar requirements. 60 Schell recognizes that
the preferred return can affect the performance of management, noting that “a Preferred
Return serves the alignment of interest concept by linking the Carried Interest to superior
performance.” 61 Schell acknowledges that the carried interest may not always reflect
superior performance, but he remains unconvinced of its virtue. 62 “From a purely
analytical point of view,” he notes, “it is not obvious that no Carried Interest should be
payable unless investment returns exceed a specified level.” 63
Schell defends the status quo by drawing an analogy to the compensation of public
company executives. Compensation structures, he explains, do not always impose a
requirement that executives exceed a benchmark. “For example,” he continues,
“corporations frequently grant stock options to executives and establish the exercise price
based on the underlying stock price on the date the option is granted.” 64 Despite the fact
that the exercise price is fixed and does not increase over time, “[t]he interests of the
executive are considered aligned with those of the shareholders in the sense that the stock
must appreciate in order for the option to have value.” 65 Schell recognizes that this
approach—by far the most common approach for compensating public company
executives—may reward mediocre performance: “[T]he corporate executive participates
in the appreciation of the stock on a first dollar basis” and his or her incentive
compensation is not conditioned upon superior performance. 66
To the extent that the purpose of fund agreements is merely to create horizontal
equity with public company executives, Schell’s explanation has some merit. But
Schell’s analogy does little to explain the difference between venture funds and buyout
funds. Both types of funds potentially compete with public companies for talent, and yet
only venture funds exclude a preferred return.
More importantly, Schell’s analogy provides no reason for using public company
compensation as a model for private equity compensation practices. To the extent that we
expect the LP agreement to align the incentives of investor and manager—a goal we
should also maintain for public company executives—Schell’s analogy only removes the
puzzle one level higher: Is the compensation of public company executives a good
model?
59. SCHELL, supra note 18, § 2.03[1].
60. Id.
61. Id. (“Investors sometimes express this point in negotiations by asking why they should give up 20% of
the profits attributable to their capital if a higher return could have been obtained in a money market fund or
other low risk investment.”).
62. Id.
63. Id.
64. SCHELL, supra note 18, § 2.03[1].
65. Id.
66. Id. Schell goes on to note that the analogy to public company executives may be more compelling “in
the case of smaller Funds where the fixed compensation of the Principals derived from Management Fees may
be less than that of executives with comparable levels of experience in more conventional financial
institutions.” Id. § 2.03.
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Executive stock option practices may be flawed. 67 Lucian Bebchuk, Jesse Fried, and
David Walker argue, for example, that at-the-money options serve as a rent extraction
device, allowing executives to maximize pay while minimizing outrage costs. 68 Central
to their argument is the fixed at-the-money strike price of the typical option package. By
failing to index the strike price of the option to industry benchmarks or to account for the
time value of the option, options allow executives to camouflage their compensation and
avoid incurring outrage costs by offended shareholders. 69 In a recent article, Michael
Jensen and Kevin Murphy conclude that corporate boards should consider cost-of-capital
indexed options to make executives more sensitive to performance. 70 Because many of
the norms and institutional factors that lead to non-indexed options in the public company
context are not present in the private equity context, this literature has limited direct
application to the puzzle of the missing preferred return. 71 What is clear from this
literature, however, is that few commentators would adopt executive stock options as a
suitable model for private equity practices.
E. Distorting Incentives
An industry report by a trade group, Asset Alternatives, provides a promising
explanation: perhaps venture funds do not include a preferred return because a preferred
return might distort, rather than align, the incentives of the GPs. 72 Implicitly, the report
recognizes that the presence or absence of a preferred return term can affect VCs’ attitude
toward risk. But thinking about the issue is rather muddled. In discussing preferred
returns, the report notes that for reasons that are quite specific to the dynamics of venture
capital investing, LPs generally have refrained from seeking preferred returns on venture
funds. 73 The report explains that the primary reason for LP restraint here is the fear of
“unintentionally distort[ing] the incentives that ordinarily motivate” the VCs. 74
The report cites two examples of how a preferred return might distort incentives.
First, the report explains, a preferred return term might make VCs too cautious. “The
concern is that, in order to ensure that they achieve the preferred return goal, a venture
capital group might make conservative investments that have limited upside but also
quite limited downside.” 75 Second, the report explains that if the VCs strike out on their
first handful of deals, the added hurdle of a preferred return might lead them to give up
67. See Saul Levmore, Puzzling Stock Options and Compensation Norms, 149 U. PA. L. REV. 1901, 190608 (2001) (identifying problems with traditional option plans); David M. Schizer, Reducing the Tax Costs of
Indexed Options (Columbia Law Sch. Ctr. for Law & Econ. Stud., Working Paper No. 208, 2002), available at
http://ssrn.com/abstract=320277 (arguing that tax advantages offered when stock options are used as executive
compensation should be reformed).
68. Lucian A. Bebchuk, Jesse M. Fried & David I. Walker, Managerial Power and Rent Extraction in the
Design of Executive Compensation, 69 U. CHI. L. REV. 751, 784 (2002).
69. Id. at 789-91.
70. See Jensen & Murphy, supra note 3.
71. See Levmore, supra note 67.
72. See TOLL, supra note 21, at 53.
73. Id. at 16.
74. Id. at 53.
75. Id.
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hope prematurely. 76
The first example—making GPs overly cautious—is unpersuasive. The preferred
return term has the effect of making the GPs less cautious, not more. If the benchmark is
raised, the manager must perform better and take more risk to achieve the higher goal.
Moreover, it is not clear that it is possible for VCs to be both cautious and yet still
confident that they could exceed an 8% return. After all, if safe investments yielding
greater than 8% were readily available, one would not need an intermediary to invest.
Rather, just the opposite is true: a preferred return eliminates the possibility of GPs sitting
back and making safe investments rather than aggressively sourcing investments. 77
The second example—the early strikeout example—is more plausible. After a few
failures, a GP might become increasingly desperate and make risky and negative net
present value investments in the slim hope of landing a big fish. A GP might even
abandon a fund with early strikeouts or pay little attention beyond the minimum needed
to justify acceptance of the management fee.
If the early strikeout problem were the driving force behind the absence of a
preferred return, however, one might expect a different solution. The partnership
agreement could calculate carry on a deal-by-deal basis, as was done in the early days of
venture funds. Alternatively, LPs could volunteer to “re-price” the preferred return, just
as public company compensation committees often re-price stock options when the
options are deep out of the money. 78 Furthermore, if the early strikeout problem were
truly the paramount concern, one might expect GPs to receive a percentage of the fund,
not just a percentage of the profits. Giving GPs something to lose on the downside as
well as something to gain on the upside would eliminate this distortion of incentives.
The effect of the preferred return on the incentives of the GPs is the most promising
line of inquiry. Bargaining power, history, cash flow, and horizontal equity offer some
superficial appeal, but none holds up well under closer scrutiny. Incentives might. The
existing literature does little to clarify exactly what incentives the absence of a preferred
return creates. Is it intended to make GPs risk averse or to help them overcome risk
aversion? If it is intended to change risk preferences over time, then why is it structured
with a fixed hurdle rate? I turn to these questions now in Part IV.
IV. THE EFFICIENCY (AND INEFFICIENCY) OF THE PREFERRED RETURN
The partnership agreement guides the behavior of the managers and investors.
Compensation terms are no exception; contractual provisions regarding VC pay are
designed to attract, incentivize, and reward good performance, and to deter and penalize
shirking. To understand whether a preferred return would improve incentives, I consider
76. Id.
77. See supra Part II.A.1.
78. A consistent practice of re-pricing the preferred return might distort ex ante incentives; but then again
so does failing to include a preferred return. Eliminating the preferred return distorts incentives in all cases ex
ante, but improves incentives only in a few (those funds that have some early strikeouts). Nor does excluding a
preferred return really solve the early strikeout problem. All it does is keep an out of the money carry from
becoming deeper out of the money over time. Anytime the carry is out of the money, the VC will have an
incentive to take more risk than is optimal from the investors’ point of view. A better solution would be to give
the VC a capital interest rather than a profits interest in the fund.
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the context of how VCs create value over the life of a fund.
A. Aligning Incentives
Private equity faces a familiar problem: the separation of ownership and control.
LPs contribute capital to the fund but do not directly control the use of the capital, instead
relying on GPs to invest on their behalf. Several factors create an incentive for GPs to
work hard, find good portfolio companies to invest in, and spend time working with
management of these companies to increase their value. These factors include fiduciary
duties, management fees, reputation, and the carried interest.
Fiduciary duties do not provide a strong incentive to work hard. In theory, the GP of
a partnership has strong fiduciary duties to its partners. In Meinhard v. Salmon, Justice
Cardozo explained that partners owe one another “the duty of the finest loyalty . . . . Not
honesty alone, but the punctilio of an honor the most sensitive, is then the standard of
behavior.” 79 While academics are fond of trotting out Cardozo’s famous dictum, this
exaggerates the state of the law. 80 The business decisions of GPs are effectively insulated
from court review. 81 The common law provides incentives not to lie, cheat, or steal, but
not much of an incentive to work especially hard or to be especially talented in the first
place.
The management fee also fails to provide a strong incentive to work hard. GPs
typically receive an annual management fee of between 1% and 3% of the capital
committed to the fund. 82 The management fee pays for the administrative expenses of the
fund, legal expenses, and pays the salaries of the professionals who work for the GPs.
The management fee is not contingent on the profitability of the fund. Because the
management fee is paid regardless of the fund’s performance, it creates only a weak
financial incentive. The only recourse for unhappy LPs is to seek the removal of the GP,
a drastic step that is difficult to accomplish under most contracts. If anything, then, the
quasi-guaranteed management fee creates an incentive to be somewhat tentative and risk
averse; a mediocre GP who follows the herd is unlikely to be ousted absent self-dealing
or some other breach that is easier to prove.
Reputation provides a significant performance incentive for some funds. By the third
or fourth year in the life of a typical fund, the GP has already begun raising money for its
next fund. LPs considering investing in the next fund will conduct considerable diligence
on the prior performance of the GP. Nonetheless, reputation is only a partial solution to
79. Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y. 1928).
80. See STEPHEN M. BAINBRIDGE, AGENCY, PARTNERSHIPS & LLCS 139 (2004) (noting that even in the
duty of loyalty context, it is not necessarily a violation to further one’s own interest); see also Larry E. Ribstein,
Are Partners Fiduciaries?, 2005 U. ILL. L. REV. 209 (2005) (arguing that partners are not fiduciaries because
they do not delegate open-ended control to their partners).
81. See BAINBRIDGE, supra note 80, at 176 (noting possible application of business judgment rule in
partnership context). In a recent high-profile case, a private equity fund was found to have breached its
fiduciary duties by making investments in excess of a contractual cap. The jury, however, refused to award
damages, finding that the investors had ratified or acquiesced to the investments. See Jeffrey Tabak & Caroline
Kraus, Verdict Reached in Connecticut v. Forstmann Little, PRIVATE EQUITY ALERT (Special Edition) (Weil,
Gotshal & Manges, LLP, New York, N.Y.), July 2004, available at http://www.altassets.com/pdfs/weiljuly.pdf.
82. This amount sometimes decreases in the later years of the fund, when most of the fund’s capital has
been committed and the expenses of the fund decrease.
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the agency costs problem. Within the group of professionals that make up the GP, some
individuals may be more talented than others, but performance metrics rarely track the
involvement of each individual manager. As an individual works hard and creates value
for the fund, his colleagues may share the benefit. An individual who locates a portfolio
company that proves successful, however, may see a direct increase in her own
compensation, depending on the fund’s internal profit sharing rules. 83
The carried interest thus provides the most powerful incentive to work hard. A large
carry is one of the hallmarks of a private equity fund, and is considered essential to
attracting talented managers. While private equity managers could live well on their base
salaries alone, they would not be truly rich. Only the compensation of the carried interest
of a successful fund can do that, and it is the prodigious carry of successful private equity
funds that lures professionals away from investment banks, commercial banks, and other
investment management companies. 84
B. The Option Analogy
Characterizing the carried interest as an option can help us understand the conditions
under which the current design of the carried interest in venture funds properly aligns
incentives. 85 In this case, the carried interest most closely resembles a call option, a
common derivative used in the capital markets. 86 A call option gives the holder the right,
but not the obligation, to buy a fixed amount of the underlying stock for a fixed price at
some point in the future.
To be more precise, a 20% carry is financially equivalent to a call option on 20% of
the value of the fund. The holder of the carried interest, like the holder of a call option,
enjoys the possibility of theoretically unlimited upside gain but bears no risk of loss. If
the fund increases in value, the GP shares in the profits, just as would happen when an
option holder exercises an option. If the fund loses value, the GP has neither gain nor
loss, again, just like an option holder who declines to exercise an option.
A numerical example may help illustrate the analogy. A 20% carried interest is
financially equivalent to a call option on 20% of the value of the fund, with a fixed
exercise price equal to 20% of the initial investment in the fund. Consider a fund with an
initial capital amount of $100. If the fund appreciates to $400, the GP has the right to call
20% of the fund (20% of $400, or $80) at a strike price of 20% of the initial capital
amount (20% of $100, or $20). The difference between the current market value of the
option ($80) and the strike price ($20) represents the GP’s profit ($60). This $60 profit on
the option is equivalent to a carried interest of 20% of the overall $300 profit of the fund.
The analogy holds on the downside: if the value of the fund declines below its initial
83. Internal GP compensation practices are an even bigger mystery than GP-LP practices. Many GPs
appear to adjust carried interest shares according to the involvement of each individual in a particular deal. See
SCHELL, supra note 18, § 4.04[4] (describing different internal GP compensation practices).
84. Some VCs who have already achieved financial independence may be motivated more by the psychic
satisfaction of creating new technologies and finding the next Google or funding a biotech company that cures
cancer. At the margins, however, most VCs remain sensitive to financial considerations. Few, after all, would
do this work for free.
85. See Sahlman, supra note 14, at 496.
86. Id.
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value, the carried interest has no current liquidation value, just like the holder of an outof-the-money call option.
Figure 3: Call Option
Option
Holder
Profit
54
Call Option
0
216
100
270
Total Fund Value
Figure 4: Carried Interest
GP
Payout
54
Straight
Carry
0
216
100
Total Fund Value
270
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The option analogy is useful because it allows us to tap into the extensive research
on executive compensation in the context of public company executives. Executives of
public companies typically receive a pay package that includes a cash salary and stock
options, with the options typically having a strike price at-the-money and a ten-year term.
To index an option means to reset the strike price according to a formula. For
example, one might set the strike price of an option to move along with a basket of stock
prices. An executive at Delta Airlines, for example, might receive options with a strike
price based on an index of the stock prices of American, United, and Continental. If the
whole airline industry falls upon hard times, pushing all airline stocks down, but Delta
weathers the storm better than its competitors, then the strike price of the option drops
along with the basket, allowing the Delta executive to be rewarded for her superior
performance relative to her peers at other airlines. If airline stocks soar but Delta falls
behind, the executive will not be rewarded. 87
A second type of indexed options, cost-of-capital indexed options, moves the strike
price higher over time to reflect the company’s cost of capital. 88 Thus, if the company’s
cost of capital (the amount of interest or expected return it must pay to raise additional
money in the capital markets) is 10%, the strike price of the executive’s option will
increase by 10% per year. If the company’s stock price rises slowly, but does not match
the investors’ expected return, then the executive will not be rewarded.
Options, whether indexed or not, have a significant drawback: when they are out of
the money, they can induce overly risky behavior on the part of the executives. Imagine
an executive with options with a strike price of $100 and one year remaining until
expiration. Now suppose that the stock is currently trading at $50, and the executive is
setting the corporate strategy for the upcoming year. If the company does well but not
spectacularly well, the executive will not be rewarded; only if the company doubles its
stock price will the executive receive anything. The executive may then become overly
risk-seeking, taking unwise gambles, even if such gambles have a negative net present
value to the shareholders.
Some critics of stock options have suggested that executives should receive
restricted stock rather than stock options. 89 Restricted stock can improve incentives
between the shareholders and the executive by giving the executive something to lose on
the downside as well as something to gain on the upside, just like shareholders. 90 A
drawback of restricted stock, however, is that it may not work well for risk-averse
executives, who may become too focused on preserving value rather than creating
additional value in the firm.
How does the carried interest compare to executive stock options? The carried
interest is equivalent to a call option with an at-the-money strike price. A carried interest
with a true preferred return is equivalent to a cost-of-capital indexed option. Restricted
87. For a discussion of indexed options, see Levmore, supra note 67.
88. See G. Bennett Stewart III, Remaking the Public Corporation from Within, HARV. BUS. REV., JulyAug. 1990, at 126-27.
89. See Jensen & Murphy, supra note 3.
90. Restricted stock may also appeal to executives who demand a high risk premium with options, thereby
allowing companies to save on overall compensation. See Brian J. Hall & Kevin J. Murphy, Stock Options for
Undiversified Executives, 33 J. ACCT. & ECON. 3, 37 (2002) (discussing the consequences of stock option
compensation for executives).
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stock is not equivalent to any type of carried interest at all but rather to a capital interest
in the partnership. The analogy is easy; the hard part is figuring out exactly what this
means for venture funds. I turn now to this task.
C. The Efficiency and Inefficiency of the Preferred Return
There are tradeoffs, even in a world without taxes. When pay is contingent on
performance, VCs have a stronger incentive to succeed. But because the success of a fund
is not entirely within their control, VCs demand a risk premium when their pay is
contingent. Paying for mediocre performance is a bad deal, but risk premium makes
paying for performance costly in a different way. Pay should be linked to performance if,
but only if, linking them together increases the expected value of the fund above and
beyond the amount of risk premium paid to the VC. 91
To get better traction on this question of efficient compensation design, I focus on
two areas where financial incentives may stimulate better performance: deal flow and
deal harvesting. Deal flow relates to the VC’s ability to find good portfolio investments.
Deal harvesting relates to the VC’s ability to bring those investments to a successful exit.
Because not all venture firms are the same—VCs have different reputations, abilities, and
risk tolerance—there may not be a single optimal compensation design. But we can
nevertheless draw some conclusions about the relative efficiency and inefficiency of
different compensation schemes through closer examination of the context in which VCs
perform their duties for investors.
1. Assumptions
It may be useful to spell out my assumptions about what makes a certain
compensation design efficient. I make four assumptions. First, I assume that VCs are
motivated in part by financial incentives. Perhaps some VCs are rich enough that they
would work for free. But the ubiquity of the carried interest suggests that money
influences VCs’ decisions about how much effort to expend choosing, advising, and
monitoring companies.
Second, I assume that some VCs have better reputations than others, and that
investors can discover these reputations at low cost. Reputation is important in many
business contexts, but perhaps especially so in venture capital. Sand Hill Road is a tightknit community, and word gets around quickly. 92 VCs network with entrepreneurs,
investors, and amongst themselves, in person, by email, and on blogs.
Third, I assume that VCs value their reputations and can be expected to try to act in
ways that will preserve their reputations. Reputational constraints are powerful because
91. See generally Jensen & Murphy, supra note 3.
92. Dozens of venture capital funds are located along Sand Hill Road, near Palo Alto, California. This not
only facilitates networking and allows them to keep a close eye on the portfolio companies they invest in, but it
also creates a community where word gets around and monitoring VC behavior is relatively easy for investors.
See ANNALEE SAXENIAN, REGIONAL ADVANTAGE: CULTURE AND COMPETITION IN SILICON VALLEY AND
ROUTE 128 39-40 (1996) (discussing the reasons for business success in Silicon Valley and business decline
along Route 128 in the 1990s); Ronald J. Gilson, The Legal Infrastructure of High-Tech Industrial Districts:
Silicon Valley, Route 128, and Covenants not to Compete, 74 N.Y.U. L. REV. 575, 586-94 (1999) (discussing
high-tech startups in Silicon Valley).
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investors are repeat players. Institutional investors such as pension funds, university
endowments, and insurance companies return to the venture capital market again and
again, and are in a position to punish VCs who misbehave by refusing to invest in their
next fund. 93
Lastly, I assume that VCs are risk averse. Venture capitalists hardly fit the
stereotype of a Nervous Nelly. VCs are often thought of as free-wheeling innovators who
like risk for its own sake. They are the cowboys of the investment world. But the cultural
stereotype may be a bit of an exaggeration. VCs take calculated risks, and they do so with
other people’s money. There is little reason to think that when it comes to their own
personal finances, VCs behave all that differently than other executives. Like everyone
else, VCs enjoy decreasing marginal utility from each additional dollar that they earn. For
highly successful VCs, this may just mean that their first private jet is more dear than
their second. But most VCs have a salary structure similar to a typical investment
banker. 94 Venture capitalists have high recurring expenses for mortgage payments, car
payments, private school tuition, and the like. Given a choice between $10 million over
the next ten years or a 50-50 shot at $21 million, most VCs would choose the sure thing.
VCs cannot diversify away their firm-specific risk, and so they demand a risk premium
when compensation is tied to firm performance. 95
2. Deal Flow Incentives
With these assumptions in mind, I turn now to the context of how VCs create value
to consider whether the carried interest properly aligns incentives. VCs are not passive
money managers. They create value for their investors by locating good portfolio
companies, choosing well among possible investments, and negotiating favorable
investment terms. This activity in the early years of a fund’s existence can all be
bracketed as relating to “deal flow.” Deal flow comes easy to elite VCs. When
entrepreneurs seek funding for a new idea, they turn first to the royalty of Silicon Valley:
Kleiner Perkins, Sequoia, Benchmark, and other elite venture funds. Entrepreneurs know
these well-established funds can provide valuable capital, management expertise,
93. Gilson, supra note 12, at 1090; GOMPERS & LERNER, supra note 13, at 240.
94. On the surprising stress of maintaining a wealthy lifestyle, see generally TOM WOLFE, BONFIRE OF
THE VANITIES (1987).
95. Research by financial economists supports the assumption that VCs are risk averse. A model by
Professors Charles Jones and Matthew Rhodes-Kropf finds that a straight carried interest best aligns the
incentives of the risk averse VC with the principals. Charles M. Jones & Matthew Rhodes-Kropf, The Price of
Diversifiable Risk in Venture Capital and Private Equity 5 (May 2003) (unpublished manuscript), available at
http://ssrn.com/abstract=342841. A capital interest would encourage VCs to diversify away some firm-specific
risk by investing in too many portfolio companies. A straight carried interest, by rewarding the VCs for
volatility, moderates the risk aversion. A preferred return, however, would go too far, encouraging too much
risk-taking at the cost of returns. Id. at 23. The Jones-Rhodes-Kropf model is useful, but fails to fully answer the
question at hand, which is why LBO funds are subject to preferred returns, but VCs are not. Some of their
assumptions, moreover, are questionable as they pertain to the question at hand. For example, they assume that
VCs are not limited in the number of projects they can invest in. Id. at 7. By contract, however, most VCs
cannot invest in more than 10 to 20 projects. It is possible, then, that it may be more efficient to compensate
VCs with a capital interest, and address the over-diversification problem with a contractual restriction.
Moreover, the model fails to reflect the impact of taxes, which may distort the incentive effects considerably, as
I discuss below.
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customer contacts and executive staffing contacts to help the company grow. With
talented entrepreneurs knocking at the door, high-reputation VCs can be choosier about
which deals they fund, and they might be able to negotiate better terms. Lesser-known
VC funds can also achieve good deal flow, but they must work a bit harder to get it. VCs
do this by attending technology conferences, networking with entrepreneurs and other
VCs, studying developing technologies and industries, working with university
researchers, and so on. 96
Deal flow sometimes refers only to the rate at which firms receive potential offers of
investment. I use the term more broadly to encompass not just receiving a high number of
potential deals, but also to refer to the quality of the deals and the VCs’ ability to turn
those potential deals into actual closings with attractive deal terms. Venture capitalists
exercise discretion in choosing projects and negotiating the terms of investment. The due
diligence process has become more important in recent years. Before investing, VCs
often interview everyone they reasonably can, including founders, managers, suppliers,
and customers. VCs must research the relevant markets and competition to assess the
portfolio company’s likelihood of success.
The ability to secure good deal flow is especially important in a market environment
where there is “money chasing deals.” VCs today report a scarcity of ideas and
entrepreneurs relative to the amount of money that continues to flow into the venture
capital sector. A thin market for entrepreneurs creates a moral hazard risk: VCs will be
tempted to invest all of the committed capital, even if not every investment is likely to be
profitable. In particular, VCs with weak networks may have trouble sourcing deals and
may accept the first proposals to come along, regardless of their likelihood of success.
Even for VCs with strong deal flow, accepting proposals quickly might allow the VCs to
turn their attention to other tasks, like raising money for their next fund.
A preferred return can help align the deal flow incentives of the VC with the goals
of their investors. If compensation is contingent on exceeding a preferred return, VCs are
more likely to invest only in companies that are likely to exceed this return. To address
the parallel concern in the public company context, Professors Jensen and Murphy argue
that companies should consider giving executives cost-of-capital indexed options. 97 A
cost-of-capital indexed option addresses the opportunity cost when executives invest
money in deals that offer subpar returns; it would be more efficient if they returned the
money to the investors to allow them to invest elsewhere. By raising the strike price over
time, cost-of-capital indexed options make executives aware of the hurdle rate they must
achieve to satisfy investors, and it gives them the financial incentive to do so.
Extending this model to the venture capital context is tricky. Context matters; VCs
may not face the same choices that public company executives face. To understand the
impact of compensation design on deal flow incentives, I consider four possible
compensation designs: a true preferred return, a hurdle rate, a straight carried interest
with no preferred return, and a capital interest in the partnership. Other compensation
designs are possible: one could imagine a tiered carried interest where the percentage of
96. For an empirical study on the importance of VC networking, see generally Yael Hochberg et al.,
Whom You Know Matters: Venture Capital Networks and Investment Performance (Sept. 2005) (unpublished
manuscript), available at http://ssrn.com/abstract=631941.
97. See Jensen & Murphy, supra note 3.
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the carry increases as the amount of profits increase. For example, VCs could receive
10% of the first $10 million in profits, 20% of the next $10 million, and 30% of any
additional profits. Or one could imagine a carried interest that is indexed to the
performance of peer funds. For (relative) simplicity, however, it seems useful to consider
the efficiency of the most common compensation schemes—a hurdle rate and a straight
carried interest—and two closely related schemes that seem to improve efficiency over
the status quo—a true preferred return and a capital interest in the partnership.
If encouraging VCs to create good deal flow and to properly exercise discretion in
funding projects is the paramount goal, then a true preferred return appears to be more
efficient than the alternatives. 98 A preferred return rewards VCs with a share of the
profits only to the extent they choose projects that exceed the investors’ cost of capital.
When VCs find companies that seem unlikely to meet the necessary return, they will
have an incentive to engage in further networking to find better alternatives.
Buyout funds’ use of an 8% preferred return thus seems to reflect investors’
concerns about how fund managers choose portfolio companies. At the same time, if the
goal is to create the financial equivalent of a cost-of-capital indexed option, then the
industry standard hurdle rate of 8% used by many private equity funds seems rather
arbitrary. An investor’s cost of capital might be lower or higher than this amount, and
would be expected to vary as interest rates rise and fall. It may be that the common use of
8% as a hurdle rate reflects the peculiar nature of venture capital and private equity,
where many investors are pension funds. The 8% number may have originated from a
demand by pension funds, which often use a discount rate of 8% to calculate their future
liabilities. To the extent private equity investments can clear this discount rate, pension
fund managers are achieving the return necessary to improve the financial security of
their own principals.
While a preferred return can improve deal flow incentives, the increase in efficiency
comes at a cost. Because the carried interest starts “later,” that is, at a higher strike price,
VCs will demand a higher percentage of carried interest so that if they do exceed the
expected return, they are compensated at least as well as if they had received the straight
carried interest. Investors might have to offer VCs a higher percentage of the profits—
say, 30% instead of 20%—to get them to accept the true preferred return. If aligning deal
flow incentives increases the likely total return by a sufficient amount, then investors
should be willing to pay a higher percentage of carry, since aligning the incentives will
nonetheless increase the net present value of their investment in the fund.
Risk aversion complicates the analysis further. Risk aversion will lead even VCs
who are confident in their abilities to demand an additional risk premium if their
compensation is subject to a true preferred return. Even superbly talented VCs face
uncertainties with any portfolio company, ups and downs in the market, and an exit
strategy that depends in part on a vibrant IPO market. Fund agreements limit the range of
companies that VCs can invest in, making diversification difficult and increasing firm-
98. Risk aversion makes the optimal design difficult to figure out, even if deal flow incentives are the only
goal and tax consequences are ignored. Because VCs are risk averse, they will value the first dollars of carry
that they receive more than the additional dollars, and thus may work harder to clear the hurdle and worry less
about by how much they clear the hurdle. A preferred return with a tiered carried interest rate might be more
efficient.
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specific risk. Investors might have to offer VCs an even higher percentage of the carry,
perhaps 35%, in order to compensate the managers for the increased risk associated with
the preferred return. Nonetheless, the trade-off may be a good one if the investors need
assurance that the managers they are hiring are competent. 99
A formal model of optimal compensation design for risk averse venture capitalists is
beyond the scope of this Article. For present purposes, it is sufficient to recognize that
because investors must compensate VCs for the increased risk associated with making a
carry subject to a true preferred return, the preferred return is a somewhat costly device to
screen talent and manage the agency cost problem. For some funds, relying on reputation
may be a more efficient solution. Investors in prestigious funds can be confident that the
VCs will have little trouble finding good deals and choosing the pick of the litter.
Because venture funds will want to preserve their reputation to aid in future fundraising
efforts, investors can have some confidence that VCs with strong reputations will get
them into the right investments. Because the risk aversion of VCs makes a preferred
return costly, we would expect to see it employed only when deal flow incentives are
paramount. The institutional quirks of the venture capital industry, with relatively small
networks of entrepreneurs, VCs, and investors, create a plausible story that investors in
funds with strong reputations have no need to employ a true preferred return. 100
Deal flow incentives can thus help us understand why some venture capital funds
might use a preferred return. But the few VC funds that do employ a preferred return use
a hurdle rate, not a true preferred return. Why? Recall that VCs will demand a risk
premium in exchange for giving investors a preferred return. A hurdle rate may be more
efficient than a true preferred return if it properly aligns deal flow incentives but is less
risky for VCs. And a hurdle rate does help align deal flow incentives. VCs who are not
confident that they can clear 8% will value their compensation less and will look for
other work. And a hurdle rate, like a true preferred return, encourages VCs to choose
investments that in the aggregate will clear 8%.
But a hurdle rate introduces a new distortion. Imagine that a VC is considering three
deals: a low-risk, low-return company that will return $105 in one year on a $100
investment; a medium-risk, medium-return company that has an 80% chance of returning
$110, but has a 20% risk of returning $105; and a high risk, high-return company that has
a 20% chance of returning $130, but has an 80% risk of returning $105. A risk neutral
investor would prefer the high-risk, high-return option, as it maximizes the expected
return.
99. One recent model in the public company context finds that, after accounting for executive risk
aversion and effort aversion, at-the-money or in-the-money options are optimal. See Oded Palmon et al.,
Optimal Strike Prices of Stock Options for Effort Averse Executives (European Fin. Ass’n 2004 Maastricht
Meetings Paper No. 1425, 2004), available at http://ssrn.com/abstract=559922. The impact of risk aversion
should not be overstated, however. VCs also receive some compensation in the form of management fees,
which are not contingent on the performance of the fund. Because VCs receive some riskless return, the
additional compensation in the form of carry may not be discounted for risk as steeply as one might think at first
glance.
100. See Covitz & Liang, supra note 35 (finding that preferred returns are more common at young firms,
thus suggesting a screening effect).
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A hurdle rate, however, does not lead the VC to choose this option. 101 The hurdle
rate screens out the low-risk, low-return option, but it allows the manager to receive its
full share of carry on either the successful medium or high-risk investment. Because the
catch-up provision allows the manager to gain its full share of carry as the return of the
fund moves from 8% to 10%, the manager may concentrate on clearing the hurdle rather
than maximizing total value. VC risk aversion may magnify the distortion. Assuming a
declining marginal utility of wealth, the medium-risk, medium-return strategy will be
even more appealing than the high-risk, high-return strategy. 102
A straight carried interest provides weaker deal flow incentives than a true preferred
return or hurdle rate. Risk-averse managers no longer have an incentive to reject even
low-risk, low-return investment opportunities. A sure thing that achieves a 6% return will
be attractive, even though this is not the sort of bet their investors have in mind. This
moral hazard risk should not be overstated—one may address this concern in ways other
than compensation design. Venture capital fund agreements routinely limit by contract
the sorts of companies that the fund may invest in. For example, a fund may be limited to
making investments in early-stage computer software companies. While one might find
both medium-risk and high-risk companies, one is not likely to find a low-risk early-stage
computer software company to invest in. Thus, a straight carried interest may be nearly as
effective as a true preferred return in encouraging good investments. A straight carried
interest does have a significant weakness, however, when it comes to screening out bad
VCs. Few VCs are unable to achieve a positive return, and so few will be deterred by a
compensation scheme that rewards performance even when that performance is subpar.
A capital interest in a partnership provides the weakest deal flow incentives. It
provides no screening effect; even the worst VCs will not destroy the entire value of the
fund. Moreover, a capital interest in a partnership may encourage VCs to shy away from
risky investments. The compensation curve is upward sloping, so there is an incentive to
source and fund companies with a higher expected return. Because VCs are risk averse,
however, at the margins they may shy away from riskier investments.
In sum, for funds where deal flow incentives are important, equity-based
compensation should offer VCs no reward for investments that do not return at least the
investors’ cost of capital. A true preferred return achieves this goal. A straight carried
interest does not. Reputation effects may mitigate some of the concerns about deal flow
incentives. Opportunity costs may provide a substantial constraint on a VC’s choice of
101. Figure 5: Hurdle Rate Example
Low-Low
Medium-Medium
High-High
Expected Fund Return
$5
$9
= (10(.8)+5(.2))
$10
= (5(.8)+30(.2))
Expected GP Payout
$0
$1.60
= (10(.8)(.2)+0(.2))
$1.20
= (0(.8)+30(.2)(.2))
102. But the distortion caused by the catch-up zone may be less important in practice than it appears. It
would be difficult at the outset for VCs to distinguish between medium-risk and high-risk projects. If a VC
cannot distinguish between the two, then it will simply choose the best projects. Moreover, the hurdle rate is
calculated based on aggregate returns to date, so the strategy that maximizes net present value will also usually
maximize the chances of clearing the hurdle.
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projects. When an investor makes a capital commitment to a fund, the commitment is
capped at a certain amount. Thus, even a VC who has a capital interest in a partnership
(and thus will make money from any investment) has an incentive to turn down deals if
she is confident that better deals will come along within the fund’s investment time
frame. Opportunity costs are highest for VCs with better reputations, who have the
strongest deal flow. 103 Thus, providing strong deal flow incentives are most important for
VCs who have the weakest deal flow and thus might be more inclined to accept whatever
deals they can find.
3. Deal Harvesting Incentives
The work of venture capitalists is not finished after they invest in portfolio
companies. VCs are active investors who often sit on the board of the portfolio
companies, and sometimes even control the board. Even without board control, VCs exert
power over the portfolio companies by threatening to withhold financing for additional
rounds of investment. VCs also provide entrepreneurs with management consulting
advice, tap into their network of contacts to provide executive staffing, find relationships
with customers, and aid in strategic planning.
To encourage VCs to maximize the value of the portfolio companies, it may be
important to give them both something to gain on the upside and something to lose on the
downside. The importance of upside is obvious: if VCs earn more by increasing the value
of the portfolio companies, they will work harder and will pay more attention to
harvesting investing deals than to raising money for their next fund. The importance of
having something to lose on the downside is less obvious, but significant. If VCs have
nothing to lose, they may encourage portfolio companies to make risky bets. VCs may do
this by encouraging portfolio companies to go public before they are ready, to roll out
products without sufficient testing, or to spend more money on marketing rather than
R&D.
This effect is not unique to the carried interest. Any option-like compensation,
including the common stock of a highly leveraged firm, shares this drawback. When an
option is out of the money, the holder has an incentive to take big risks with the
company, even if such risky moves have a negative net present value.
The problem may be more pronounced in VC funds than in other contexts. The
value of venture funds is subject to a “J-curve” effect: the value typically declines in the
early years of a fund, and then increases later. 104 If the carry is far enough out of the
money, the VC may simply give up on the fund, instead shifting attention to raising
money for the next fund and letting the existing investments languish.
A preferred return or hurdle rate exacerbates the out-of-the-money distortion.
Because the strike price increases over time, VCs will face stronger and stronger
incentives to make risky negative net present value bets when offering advice to
entrepreneurs.
A hurdle rate introduces an additional inefficiency through the catch-up provision.
103. I assume that VCs who have a strong reputation with investors also have a strong reputation among
entrepreneurs seeking funding.
104. See Fleischer, Fickle Investors, supra note 20, at 815 n.10.
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Suppose a fund has one remaining portfolio company, Epsilon Corp. The LPs originally
contributed $100 to the fund and have received back, to date, $216. The GP is right at the
cusp of clearing the hurdle rate. Now the fund is presented with an offer to sell its Epsilon
stock for $30; alternatively, it could hold on to the stock for another year. If the fund
holds on to the stock, there is a 25% chance Epsilon will go public and the stock will sell
for $180, and there is a 75% chance of failure, in which case it will receive nothing. This
should not be a close call. The IPO play has a present value of $45; the sale would net
$30. For the GP though, incentives push it to sell. Every dollar from the sale would be
allocated to the GP; the LPs would receive nothing. If Epsilon goes public, on the other
hand, the first $54 would be allocated to the GP, and the remaining $126 would be split
80-20 in favor of the LPs, leaving the GP with an additional $21 and a total of $75. Given
the 75% chance of failure, the present value of the IPO play, to the GP, is $19, far less
than the $30 from the sale. Consequently, the GP might opt for the safer exit. Of course,
it is possible that this situation rarely comes up in the real world. Moreover, the GP might
enjoy more fundraising value from a high profile IPO than a quiet sale, implicitly pushing
up the value of the riskier strategy. Still, the use of catch-up provisions is puzzling from a
governance perspective. 105
The ready availability of alternatives makes the use of catch-up provisions
especially troubling. Practitioners sometimes say that they do not want to “slow down”
the carry beyond the 8% hurdle; a 100% catch-up provision certainly speeds up the carry
to 20% as quickly as possible. Nonetheless, a tiered carry could accomplish much the
same goal without distorting incentives as badly. 106
A straight carried interest is somewhat more efficient than a preferred return with
respect to deal harvesting incentives. A straight carried interest will sometimes suffer
from the same distortions that all option-like instruments share: distorted incentives when
the option is out of the money. Because the straight carry has a lower strike price,
however, it is less likely to fall out of the money, and less likely to be deep out of the
money, when the distortion of incentives is the greatest concern.
Does deal harvesting solve the puzzle of the missing preferred return? Not quite. If
the paramount goal of investors is to eliminate the possible bad incentives of an out of the
money carry, the logical solution would be to lower the strike price, or to eliminate the
option-like feature of the carry altogether. One would do this by replacing the carried
interest with a capital interest in the partnership. A capital interest in the partnership
eliminates the distortions of the carried interest. Because VCs have something to lose on
the downside and something to gain on the upside, incentives between VCs and investors
are more closely aligned. Risk-averse VCs, however, may act in too conservative a
manner. Investors concerned about risk aversion might consider increasing the amount of
equity-based compensation as returns increase, for example, by giving VCs an additional
2% of the fund for every 10% increase in the internal rate of return (IRR).
105. A partial fix is to slow down the catch-up provision by allocating 50% of profits to the GP rather than
100% during the catch-up period. This extends the distorted area of return on the graph, but better aligns
incentives during the distortion.
106. For example, based on an initial investment of $100, the GP could receive 5% of profits from $100 to
$150, 10% of profits from $150 to $200, 15% of profits from $200 to $250, and 20% of profits thereafter.
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4. Summary
The relative efficiency of the carried interest versus the preferred return depends
largely on the reputation of the VCs. If investors are confident that the VCs are talented
and will secure good deal flow, then providing good deal harvesting incentives are most
important. The option-like characteristic of the carried interest is especially troublesome
when one adds in a preferred return. A straight carried interest still distorts deal
harvesting incentives, but not as frequently, and even less frequently for funds that have
fewer strikeouts. A capital interest aligns deal harvesting incentives best, and thus makes
the most sense for high-quality, high-reputation VCs.
If investors are less confident about the talent of the VC and its ability to secure
good deal flow, then using a true preferred return may be optimal. Bad managers will
value this contingent compensation less than good managers, and will self-select away.
Furthermore, managers will be more highly motivated to source high quality deals,
knowing that their performance compensation depends on clearing the benchmark. A
hurdle rate also provides good screening effects, but introduces additional distortions to
the deal harvesting process.
One would expect, then, to see a clientele effect. For established institutional
investors who can get into the most prestigious funds, one would expect VCs to receive a
capital interest in the fund. In less prestigious funds, on the other hand, one would expect
VCs to receive a true preferred return. And yet we see neither of these designs in the real
world. No funds that I know of give VCs a capital interest in the fund beyond the
traditional 1% of the fund that VCs contribute. When a carried interest is used, it is rarely
(in venture capital) subject to a preferred return. When a preferred return is used, it is
usually a hurdle rate rather than a true preferred return.
How can I explain this gap between my theoretical agency costs-based predictions
and what we observe in the real world? In the public company context, commentators
have pointed to managerial power and accounting rules as the likely cause of inefficient
contract design. Here, accounting rules are irrelevant, and managerial power seems to be
a less compelling story. There is little reason to believe that agency costs would be absent
in buyout funds, where preferred returns are used, but absent in venture, where preferred
returns are not used. What is left to explain the puzzle? When optimal contracting theory
fails, solutions tend to fall into two categories: market failure, such as monopolies or
excessively high information costs, or legal or regulatory rules that dictate the suboptimal
contract design. Here, it is a set of legal rules—the tax law—that clicks this Rubik’s Cube
into place.
V. A TAX EXPLANATION FOR THE MISSING PREFERRED RETURN
Tax provides the final move to solve the puzzle. Absent tax considerations, one
would expect to see either a true preferred return or capital interest, depending on the
reputation of the VC. For VCs with mixed or unknown reputations, one would expect to
see a true preferred return. VCs with high reputations should simply receive a capital
interest in the partnership, which properly aligns deal harvesting incentives. But we
observe neither of these designs in the real world. Arguably, a straight carried interest
may represent a balancing act between deal flow incentives and deal harvesting
incentives. But incentives alone cannot account for the complete absence of VCs
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compensated with a capital interest. Nor can incentives account for the nearly universal
preference of hurdle rates over true preferred returns. Either investors misunderstand how
incentives work, or something else is going on.
Tax law distorts the contract design in two ways. First, management fees are treated
as ordinary income and taxed upon receipt. Carry, on the other hand, is treated as capital
gain and taxed at a lower rate. Tax thus creates an incentive to pay as much compensation
as possible in the form of carry rather than management fees. Second, the value of the
carry is not taxed upon receipt of the contract, but rather only when the underlying gains
have been realized and distributed. The option value of the carried interest is never taxed.
And so in two ways tax creates an incentive to pay as much compensation as possible in
the form of carry and as little as possible in the form of management fees.
The tax law thus subsidizes compensation for VCs, but only when it comes in the
form of carried interest. The subsidy is especially valuable in venture capital because of
the volatility of venture funds. Including a preferred return in venture capital contracts
(or, for that matter, indexing the carry to an industry benchmark or otherwise increasing
firm-specific risk) would reduce the value of the carry, thereby failing to take full
advantage of the subsidy. The lawyers and principals who draft partnership agreements
quite rationally take full advantage of the tax subsidy at the cost of somewhat inferior
contract design.
A. The Tax Treatment of Carry
The tax law creates a gap between the economics of the carried interest and its
treatment for tax purposes.
1. Timing
The first issue is timing. At the moment a fund agreement is signed, the GP receives
something of economic value. The carried interest has an option value linked to the
likelihood that the value of the fund will increase. To be sure, the option value is
uncertain, contingent as it is on the efforts of the GP and subject to all sorts of external
risks, such as the strength of the IPO market. But it has some economic value
nonetheless. From a purely economic standpoint, then, the GP should recognize some
amount of taxable income at the moment the partnership agreement is signed. But the
calculation of the option value would be very difficult to make, and even harder for the
IRS to evaluate and police.
Tax practitioners and academics have struggled for years over the problem of the
taxation of the receipt of a partnership interest in exchange for services. 107 Partnership
interests are often analytically divided into two types: capital interests and profits
interests. A profits interest is an interest that gives the partner certain rights in the
partnership (thus distinguishing it from an option to acquire a partnership interest) but
that has no current liquidation value. A capital interest both gives the partner certain
107. See, e.g., WILLIAM S. MCKEE ET AL., FEDERAL TAXATION OF PARTNERSHIPS AND PARTNERS ¶ 5.015.10 (3d ed. 1997); Laura E. Cunningham, Taxing Partnership Interests Exchanged for Services, 47 TAX L.
REV. 247 (1991); Leo L. Schmolka, Taxing Partnership Interests Exchanged for Services: Let
Diamond/Campbell Quietly Die, 47 TAX L. REV. 287 (1991).
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rights in the partnership and also has a current liquidation value. When a partner receives
a capital interest in a partnership in exchange for services, the partner has immediate
taxable income on the current value of the interest. 108 Determining the proper treatment
of a profits interest is more difficult, however, as its current economic value is difficult to
determine. In the 1974 case Diamond v. Commissioner, the Tax Court (affirmed by the
Seventh Circuit) surprised practitioners by holding that the receipt of a profits interest
“with determinable market value” is taxable income. 109
Prior to Diamond, most practitioners felt safe in advising clients that a receipt of a
profits interest was not taxable. Even after Diamond, practitioners could point to the fact
that a profits interest in a partnership rarely has a determinable market value. Some
uncertainty remained, however, until 1993, when the IRS settled the issue by conceding
that profits interests would not be taxed currently, and by further establishing that a
partnership interest with no current liquidation value would be the hallmark of a profits
interest. In this pronouncement, Revenue Procedure 93-27, the IRS announced that it
would not treat the receipt of a profits interest by a person who performs services to a
partnership in a partner capacity as a taxable event for the partner or the partnership. 110
Revenue Procedure 93-27 spelled out the limits of this safe harbor. To qualify, the
profits interest must not relate to a substantially certain and predictable stream of income
from partnership assets, such as income from high-quality debt securities or a highquality net lease; must not be disposed of within two years of receipt; and the partnership
must not be publicly traded. 111 Revenue Procedure 93-27 defines a capital interest as an
interest that would give the holder a share of the proceeds if the partnership’s assets were
sold at fair market value and the proceeds distributed in a complete liquidation of the
partnership. 112 A profits interest is defined as “a partnership interest other than a capital
interest.” 113 The determination as to whether an interest is a capital interest generally
occurs at the time of receipt of the partnership interest. 114
The typical carried interest in a venture capital fund slips cleanly, but snugly, into
the Revenue Procedure 93-27 safe harbor. The interest has no current liquidation value; if
liquidated immediately, all of the fund’s paid-in capital would be returned to the LPs.
And while the carried interest has value, it is not related to a “substantially certain and
predictable stream of income from partnership assets.” 115 On the contrary, the amount of
carry is highly uncertain and unpredictable.
Revenue Procedure 93-27 draws an arbitrary line between capital interests and
108. See, e.g., Mark IV Pictures, Inc. v. Comm’r, 60 T.C.M. (CCH) 1171, 1176 (T.C. 1990); Larson v.
Comm’r, 55 T.C.M. (CCH) 1637 (T.C. 1988) (holding that receipt of a partnership interest constitutes taxable
income); Hensel Phelps Constr. Co. v. Comm’r, 74 T.C. 939 (T.C. 1980) (holding that the value of a partnership
interest must be included in taxable income in the year the partnership agreement was executed); see also Treas.
Reg. § 1.721-1(b)(1) (as amended in 1996); Prop. Treas. Reg. § 1.721-1(b)(1)(i), 70 Fed. Reg. 29675 (May 24,
2005).
109. See Diamond v. Comm’r, 56 T.C. 530 (T.C. 1971), aff’d, 492 F.2d 286, 292 (7th Cir. 1974).
110. See Rev. Proc. 93-27, 1993-2 C.B. 343.
111. See id.; see also Rev. Proc. 2001-43, 2001-2 C.B. 191 (holding that a profits interest not substantially
vested does trigger a taxable event when restrictions lapse; recipients need not file protective 83(b) elections).
112. See Rev. Proc. 93-27, 1993-27 C.B. 343.
113. Id.
114. Id.
115. Id.
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profits interests at whether the interest has a current liquidation value. While the approach
has some intuitive appeal and some administrative advantages, there is no economic
distinction between a capital interest and a profits interest that would justify taxing them
differently when issued to a partner in exchange for services rendered. 116 By ignoring the
option value of partnership interests with no current liquidation value, Revenue
Procedure 93-27 allows partners to receive tax-deferred compensation. Because options
are more valuable when volatility increases, Revenue Procedure 93-27 is especially
valuable for partnerships that make highly risky investments—like venture capital.
VCs thus gain a significant timing benefit by deferring tax on their compensation so
long as the compensation is structured as a profits interest and not a capital interest in the
partnership. 117 But there is more than timing at issue: tax law also distorts the contract
design by treating the carried interest as investment income rather than service income,
and thus often allows the character of realized gains to be treated as capital gain rather
than ordinary income.
2. Character
Compensation for services is normally treated as ordinary income. Whether in the
form of cash salary, a performance bonus, a trip to Bermuda, or a Christmas ham, tax
generally treats all such payments as ordinary income. 118 In the partnership context,
deciding whether a distribution is compensation for services or is a share of partnership
income is a difficult issue when the recipient, like the GP here, is a partner in the
partnership. Section 83 of the Internal Revenue Code, enacted in 1969, addresses the
receipt of property in exchange for services. It provides the general rule that property
received in connection with the performance of services is income. 119 A simple reading
of section 83, then, suggests that the GP should be taxed immediately on the option value
of the carried interest, and because the carry is received in exchange for future services,
116. See Cunningham, supra note 107, at 252.
117. The net result is also more advantageous than parallel rules for executive compensation with corporate
stock. See William R. Welke & Olga A. Loy, Compensating the Service Partner with Partnership Equity: Code
§
83
and
Other
Issues
17
(Mar.
2002)
(unpublished
paper),
available
at
http://www.kirkland.com/files/tbl_s14Publications/Document1303/791/Compensating%20the%20Service%20P
artner.pdf.
The treatment of SP’s [service partner’s] receipt of a profits interest under Rev. Proc. 93-27 is
significantly better than the treatment of an employee’s receipt of corporate stock. While the
economics of a profits interest can be approximated in the corporate context by giving investors
preferred stock for most of their invested capital and selling investors and the employee “cheap”
common stock, the employee will recognize OI [ordinary income] under Code § 83 equal to the
excess of common stock’s FMV (not liquidation value) over the amount paid for such stock. In
addition, if the common stock layer is too thin, there may be risk that value could be reallocated
from the preferred stock to the common stock, creating additional OI for the employee. In
contrast, in the partnership context, the fact that partners who provide capital are merely entitled
to a return of their capital (but no yield) before SP shares in profits generally does not create an OI
risk for SP. Because the partners providing capital are entitled to a return of their capital before SP
is entitled to anything, SP’s interest is still a profits interest with a zero liquidation value.
Id. at 18.
118. I.R.C. § 61 (2004).
119. I.R.C. § 83(a) (2004).
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the exchange would seem to give rise to ordinary income. Section 707 further addresses
payments from a partnership to a partner. So long as the payment is made to the partner
in its capacity as a partner (and not as an employee) and is determined by reference to the
income of the partnership (i.e., is not guaranteed), then the payment will be respected as a
payout of a distributable share of partnership income rather than salary. Arguably, the
initial receipt of the carried interest is itself better characterized as a guaranteed payment
(as it is made before the partnership shows any profit or loss). 120 However, Revenue
Procedure 93-27 implicitly overrides this possible interpretation of sections 83 and 707.
For tax purposes, then, the initial receipt of a profits interest is not a taxable event, and
subsequent distributions will be respected as payouts of the distributable share of income.
To determine the character of payments made pursuant to the carried interest, the tax
law treats distributions of cash or securities under the terms of the carried interest as it
would any other distributable share of income from a partnership. Because partnerships
are pass-through entities, the character of the income is preserved as it is received by the
partnership and distributed to the partners. Here, the distributable share of income is
typically generated by the sale of stock in a portfolio company, which is normally capital
gain. Long-term capital gain is taxed at a lower rate than ordinary income. 121 Moreover,
the venture fund’s investment in portfolio companies sometimes fits into the definition of
“qualified small business stock,” reducing the tax rate even more. 122
Sophisticated readers may note that I have left out a significant piece of the tax
analysis: the treatment of the partnership (and thus, the impact of these rules on the other
partners). In general, treating the receipt of a profits interest by the GP as a nonevent for
tax purposes is good for the GP but bad for the LPs, as the partnership may not take a
deduction for the value of the interest paid to the GP, and the LPs lose the benefit of that
deduction. If the GP and LPs have the same marginal rates, then the tax benefit to the
GPs of Revenue Procedure 93-27 would be perfectly offset by the tax detriment to the
LPs. In fact a majority of LPs are tax-exempt and have a marginal rate of zero.
Revenue Procedure 93-27 is thus especially important in this context because the
majority of LPs are not harmed by the loss of the tax deduction. Over 50% of investors in
venture capital are tax-exempt pension funds, and other investors, such as private
foundations, university endowments, and others are tax-exempt or have lower rates.
Thus, by taking full advantage of Revenue Procedure 93-27, tax planners are not merely
120. See Cunningham, supra note 107, at 267.
Because the value of a partnership interest received by a service partner, whether capital or
profits, invariably is dependent upon the anticipated income of the partnership, the mere fact that
the right to reversion of the capital has been stripped from the interest does not convert the
property interest represented by the profits interest into a distributive share of partnership income.
Even though the value of a profits interest or capital interest cannot be determined without
reference to partnership income, the property interest itself has a fixed value, and its transfer is a
payment of a fixed amount (that is, a guaranteed payment), rather than a mere distributive share of
partnership income. Clearly, subsequent allocations of profits, either under the undivided capital
interest or under the bare profits interest, are distributive shares not subject to § 707, although the
one time transfer of the interest itself is.
Id.
121. I.R.C. § 1(h) (2004).
122. I.R.C. §§ 1202, 1045 (2004).
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redistributing value between the GP and the LPs, they are creating value for the parties by
shifting value away from the public fisc. Subject only to the limitation of the distorting
effect on contract design, it becomes rational for fund lawyers to take full advantage of
the gap between the economics of the carried interest and its treatment for tax
purposes. 123
B. The Impact of Tax on Carried Interest Design
The tax law thus provides a powerful incentive that affects the design of venture
capital compensation. By drawing a sharp distinction between a capital interest in a
partnership and a profits interest in a partnership, LPs should strive to pay GPs with a
profits interest, so long as doing so does not unduly distort incentives. Further, to the
extent that the carried interest is a substitute for other forms of compensation, LPs should
strive to pay as much as possible in the form of carry and as little as possible in the form
of cash salary.
Venture funds do exactly this. By starting the carry at nominal profits of zero,
venture funds maximize the amount of compensation paid in the form of carried interest,
which maximizes the amount of compensation deferred by the GP. If the fund employs a
preferred return, starting the carry at a higher threshold, then the fund is not maximizing
the amount of compensation paid in the most tax-efficient form. If, in response to the
imposition of a preferred return, the GP demands a higher management fee, that
management fee would be taxed upon receipt, and would be treated as ordinary income
rather than as capital gains. 124
The option analogy may again be useful. The tax law provides a strong incentive to
pay partnership executives with an option-like instrument rather than a forward-like
instrument. It also provides an incentive to establish the strike price of the option as low
as possible without putting the option in the money (which in turn would give the option
a current liquidation value and upset the tax treatment). By excluding a preferred return,
the fund sets the strike price at-the-money. By keeping the strike price fixed rather than
increasing it over time, it further maximizes the option value of the carried interest.
Moving the strike price any higher would lead to other compensation paid in less taxfavorable form; moving the initial strike price any lower would create immediate tax
liability to the GP.
To frame the problem in a slightly different way, consider the design of
compensation from a tax point of view, ignoring incentive effects. To minimize taxes, the
GPs should receive as much compensation as possible in the form of capital gains, and
should pay tax on that compensation as late as possible. A tax-efficient scheme, then,
would consist entirely of a profits interest in the partnership, and no management fee
whatsoever.
123. Given that a structure that maximizes benefits for both the GP and a majority of LPs is probably best
for all, for this and other reasons, taxable LPs gravitate away from venture capital, creating a clientele effect.
124. Levin reports that some GPs opt to reduce their management fee in exchange for a higher profits
interest, either up front (as I suggest here) or by reserving the right to periodically waive the fee in exchange for
an enhanced profits interest. See LEVIN, supra note 29, ¶ 1004, at 10-14. So long as there is some economic risk
that further fund appreciation will not occur, periodic waivers will successfully convert ordinary income into
long term capital gain. See id.
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The real world makes this difficult, however, as investment professionals need
steady income to pay fund expenses, and need to receive some salary to make mortgage
and car payments, and to live in the manner in which they have become accustomed. In
theory, GPs could borrow this amount from outside lenders using the carried interest as
collateral, but information costs make such borrowings expensive.
The next best solution, then, is to keep management fees low and maximize the
carried interest. In designing the carried interest, moreover, one would want to include
both firm-specific and non-firm-specific risk, as VCs would have difficulty hedging away
firm-specific risk. By excluding the preferred return and not indexing the carried interest,
that is exactly what venture funds do. A preferred return would move the strike price of
the option out of the money. Indexing the carry to an industry benchmark would amplify
firm-specific risk, reducing the value of the carry. In the other direction, setting the strike
price of the option in the money would give it a current liquidation value, thus upsetting
the favorable tax treatment. Although perhaps not consciously, the market for GP
compensation has found its way to the most tax-efficient result.
C. Turning the Puzzle Around
The tax explanation for the absence of a preferred return in venture capital contracts
helps solve one puzzle but creates another. If the tax incentive to pay compensation in the
form of carried interest is so powerful, then why don’t buyout funds and other private
equity funds follow suit? Tax has turned our puzzle inside out: venture funds start the
carry on a first dollar basis to pay as much compensation as possible in a tax-advantaged
form. The new challenge is to figure out why buyout funds and other private equity funds
include a preferred return. Why are preferred returns used at all? I focus on two reasons:
reputation and investment strategy.
The first reason is simple: deal flow incentives may be more important in some
funds. Even some VC funds use preferred returns, and it appears that preferred returns
became more common in venture funds as the size of the market grew, presumably
introducing more VCs of unknown reputation. Preferred returns may be more common in
buyout funds in part because it is difficult to know or rely on the reputation of buyout
managers than VCs. Buyout firms tend to be larger than VC firms, so perhaps investors
can be less confident that the managers they know will end up directing their
investments.
But the near uniformity of the preferred return in buyout funds suggests that there
must be more. The second reason a preferred return is used is institutional: outside of the
venture context, the preferred return also protects private equity investors against a moral
hazard risk. Specifically, in the absence of a preferred return, the manager of a buyout
fund might choose a low-risk, low-return strategy.
The strategy of many buyout funds is to take stodgy, underperforming companies
and turn them into streamlined high-performance firms. Buyout funds might do this by
replacing management, changing corporate strategy, or breaking the company up and
selling it off in pieces. And so a company that generated an annual return to stockholders
of 5% a year might be transformed into a company that generates, for the buyout fund, a
return of 20% or more. The carried interest gives buyout fund managers a financial
incentive to pursue this strategy by giving them a share of the upside.
Without a preferred return, however, the fund manager’s incentives may be
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distorted. After all, if the fund invests in a company that returns 5% a year, the fund
manager still enjoys 1% of the return (20% of the 5%) in the form of carried interest. The
fund manager may choose to pursue a low-risk, low-return strategy either by changing
very little about the company after the investment is made, or even by choosing
companies that have very little potential to generate large returns, but might be safer
investments.
Consider, simply for illustrative purposes, a hedge fund that starts with $1 billion in
capital and a ten-year life. Suppose the GP receives a straight carry under the terms of the
partnership agreement, just as in a venture capital fund. A sensible strategy for the GP
would be to take the $1 billion in partnership capital and buy ten-year Treasury Notes,
thus virtually guaranteeing a 6% return over the next ten years. Each year, the GP will
receive 1.2% of the return (20% of the 6%), or $12 million dollars, for doing virtually no
work and costing itself nothing beyond its reputation and ability to raise future funds. In
the hedge fund context, it’s not likely that this simplistic approach would work. Investors
would observe the investment in Treasury Notes and withdraw their capital. And the
hedge fund manager’s reputation would suffer greatly.
In the buyout context, however, it may be more difficult for investors to observe
what the fund managers are doing. While they will normally be able to find out the
identity of each portfolio company and the broad plans for reorganization of the
company, the difference between a stodgy company and a stodgy company with great
potential is highly subjective. And, unlike in the hedge fund example, the investors’
capital is locked in. Because fund managers could easily hide a low-risk, low-return
strategy, including a preferred return is important to aligning incentives, notwithstanding
the tax cost.
Reputational costs might constrain the fund manager’s decision to take the easy way
out, but the difference in investment decisions might be more subtle than in this stylized
example, making it difficult and expensive for future investors to recognize the selfinterested decisionmaking. A preferred return solves this moral hazard concern by
rewarding the fund manager only for investments that include enough upside potential to
clear the hurdle.
GPs can also lower the risk level of the portfolio by choosing diverse portfolio
companies, and investing smaller amounts in more deals than investors would like. 125 A
recent paper by Douglas Cumming and others documents the moral hazard risk, which
they call “style drift.” 126 While some style drift concerns may be addressed by contract, it
is expensive for LPs to draft and to monitor compliance with these terms. GPs are in a
better position than LPs to understand the portfolio company business plans. As a result,
addressing this agency cost indirectly through a preferred return may be more efficient—
notwithstanding the tax inefficiency—than using a straight carried interest and trying to
monitor more closely what the GPs are doing.
125. The moral hazard concern is present even when the choice is between two investments of roughly
equivalent net present value. Institutional investors treat private equity as an “alternative asset class,” meaning
that it is valued in large part for its diversification effect. Using a preferred return ensures that private equity
managers, given a choice, will never choose an investment with a likely return below 8%. The preferred return,
in other words, protects the diversification effect of private equity.
126. See Douglas Cumming et al., Style Drift in Private Equity 2 (Apr. 25, 2005) (unpublished manuscript),
available at http://ssrn.com/abstract=729684.
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For venture funds, the moral hazard risk of taking a low-risk strategy is smaller than
in buyout funds, as venture fund managers rarely find investments that are low risk. The
terms of the limited partnership fund agreements typically require the fund managers to
invest only in start-up companies or growth companies in certain industries. Reputational
constraints are stronger as well, as it is easy for investors to see the difference between a
start-up and an established company, although it may be more difficult to distinguish a
safe and mature company from a riskier one.
In the end, these institutional differences between venture funds and buyout funds,
along with the tax incentive to maximize equity-based compensation, explain the missing
preferred return. It’s difficult for buyout fund investors to monitor what buyout fund
managers are investing in, and there’s an unacceptable risk that absent a hurdle rate,
buyout fund managers will choose a low-risk, low-return strategy, at least on the margins.
Venture is different. It’s not that VCs are saints. But there’s no such thing as a low-risk,
low-return high tech start-up. Thus, taking full advantage of the tax treatment of a profits
interest in a partnership makes sense.
VI. CONCLUSION
Tax law distorts the design of venture capital compensation by encouraging the use
of risky, equity-linked compensation over management fees. Because the tax treatment is
more favorable than the economic reality, the tax law can be viewed as subsidizing VCs.
Because the market for investors is somewhat competitive, the subsidy is likely split
between the VCs and their investors. And so it is more accurate to say that the tax law
subsidizes venture capital investing, not just VCs. The normative implications are not
obvious.
In general, a gap between the tax treatment of a transaction and its economic
treatment is troubling from a policy perspective. Gaps create deadweight loss by
distorting the behavior of participants. Here, VCs may be engaging in riskier strategies
than their investors would prefer, rushing products to market and pushing management to
pursue IPO exits. Notwithstanding this potential negative externality, the status quo may
be acceptable from a policy perspective for two reasons. First, the solution may be worse
than the problem. Changing the tax law may give rise to uncertainty and administrative
headaches for practitioners and the IRS alike. Second, a tax subsidy for venture capital
may be a worthwhile expenditure of public resources. Although a full blown defense of
subsidizing venture capital is beyond the scope of this Article, a short explanation may be
useful.
Pragmatism provides the first reason to keep the status quo. Current law may be the
inevitable product of administrative concerns. The tax law fails to recognize and tax the
option value of the carried interest because it would be extremely difficult to calculate.
Unlike publicly traded options that can be valued using Black-Scholes or other models
developed by economists, the value of the carried interest depends on the efforts of the
GP. There is no option value except what the GP creates. Because LPs use the profits
interest to motivate the GP, the GP cannot sell its profits interest. It is a vastly different
situation than receiving marketable options on a publicly traded stock. Thus, agreeing on
the value of a profits interest in a partnership is no easy task, and the administrative
headaches would consume large amounts of IRS resources.
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Moreover, fund advisors could react to a change in the tax law by replacing the
carried interest with a financial equivalent: an option to acquire a capital interest in a
partnership. An option to acquire a 20% capital interest in the partnership, with a strike
price set at 20% of the initial fund value, is financially equivalent to and provides the
same incentives as the usual 20% carry. Under current law, the issuance of an option to a
service provider generally is not treated as a taxable property transfer under section
83, 127 although what happens on exercise is less clear. 128 Changing the rules on the
treatment of a profits interest in a partnership might only move the battleground to a
different, financially equivalent arena.
Economic growth provides the second reason to keep the status quo. Subsidizing
venture capital may be a good idea. Venture capital-backed start-ups create jobs. And
unlike other small businesses like restaurants, dry cleaners, or hotels, these start-ups
create new technologies and fuel expanding market sectors. The whole purpose of
venture capital is to grow small businesses into large ones. When these businesses
become large, the jobs they offer are of a higher quality, and may be less likely to be
outsourced, than jobs created by large firms. While I recognize that much more needs to
be said to justify a tax subsidy for venture capital, this provides at least reason to think
that a knee-jerk reaction to change the treatment of a profits interest in a partnership may
be unwise.
Tax law can have a powerful impact on contract design, even in an area like venture
capital where deal structures are not thought to be tax-driven. Ron Gilson and David
Schizer have argued that tax drives the basic deal structure at the portfolio company
level, leading VC funds to use convertible preferred stock. 129 Like Gilson & Schizer, I
believe delving into the tax plumbing of deals is a worthwhile endeavor. Here, I have
argued that reputation and institutional differences between buyout funds and venture
funds are the primary drivers of deal structure, but I have also argued that tax law
changes decisions at the margins. Without tax law, we could expect to see more variety in
VC fund agreements: we would see both more preferred returns (for low reputation VCs)
and also some “in-the-money” carried interests or even capital interests (for high
reputation VCs).
127. See I.R.C. § 83(e)(3) (2002); Treas. Reg. § 1.83-3(a)(2) (as amended in 2003).
128. See N.Y. State Bar Ass’n, Taxation of Partnership Options and Convertible Securities, TAX NOTES,
Mar. 4, 2002, at 1179, 1201-03.
129. See Gilson & Schizer, supra note 47, at 876.